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01/07/2013

UK: Regime Change at the BoE: Is the 'Old Lady' About to Be Shaken Up?

James Knightley and Tom Levinson, ING Bank, London.

This article appeared in the December 2012 issue of Current Economics with permission of the author.

Key Concepts: Bank of England| Monetary Policy | Quantitative Easing

Key Economies: UK, Canada

Regime Change at the BoE: Is the 'Old Lady' About to Be Shaken Up?

 

Canada Versus UK GDP Level

Asia's Total Net Oil Imports vs Crude
        Brent Oil Price

Source: EcoWin, ING

 

Household Liabilities*

Asia's Total Net Oil Imports vs Crude
        Brent Oil Price

Source: OECD

The appointment of Mark Carney as the new Bank of England Governor has received widespread backing from politicians, the press and financial markets. This largely reflects the fact that Canada has weathered the global financial crisis well. But what does Carney bring to the Bank of England (BoE)? Will it change as a result? And what is the implication for policy, rates and sterling?

On 26 November, it was announced that the current Bank of Canada Governor, Mark Carney, would be taking over the role of BoE Governor from Mervyn King, who leaves office in June 2013. Given Carney’s well-publicised denials of interest, this was a major surprise with BoE Deputy Governor, Paul Tucker, the widespread favourite for the role. Carney was clearly Chancellor Osborne’s number one target though, and by offering flexible terms and a bumped-up pay package, he eventually got his man.

The appointment has received broad support, which largely reflects the fact that Canada has weathered the global financial crisis well, seeing strong growth, employment gains and, by developed market standards, a very healthy fiscal position. How much of this is down specifically to the way Carney has run the Bank of Canada (BoC) over the period is questionable though. Critics argue that being in the right place at the right time doesn’t mean he will be a good governor elsewhere. Others would state that he could only play the hand that he was dealt and he didn’t mess up.

So, what is his background? Well, after 13 years at Goldman Sachs, Carney joined the Bank of Canada, but after a year was seconded to the Department of Finance before returning to the Bank of Canada in November 2007 as an advisor to outgoing Governor David Dodge. He then assumed the role of governor himself on 1 February 2008, in the depths of the global financial crisis. At the time, the target for the overnight interest rate was 4%, and under his stewardship, it was cut to 0.25% in April 2009, with the BoC making a commitment that interest rates would remain ultra-low for at least twelve months, well before the Federal Reserve made a similar commitment:

“With monetary policy now operating at the effective lower bound for the overnight policy rate, it is appropriate to provide more explicit guidance than is usual regarding its future path so as to influence rates at longer maturities. Conditional on the outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010 in order to achieve the inflation target. The Bank will continue to provide such guidance in its scheduled interest rate announcements as long as the overnight rate is at the effective lower bound.”
Bank of Canada press release 21 April 2009

Like other central banks, the BoC pumped liquidity into the financial system, with its balance sheet expanding to US$78.3bn in 2008 from US$53.7bn in 2007. It fell back to US$64.2bn in 2011, but has risen to US$73.2bn as of September 2012. However, the fact that Canada has been able to withdraw liquidity at a time when the Federal Reserve, Bank of Japan, European Central Bank (ECB) and Bank of England are still dramatically expanding theirs, highlights the relative success of the Bank of Canada’s efforts and the strength of the Canadian economy.

Moreover, the Bank of Canada subsequently raised interest rates by 75 basis points in 25bp steps through mid-2010 to reflect the improving domestic economy – GDP grew by an annualised 6.1% in Q1of 2010 and employment was rising, while the “spillover into Canada from events in Europe has been limited to a modest fall in commodity prices and some tightening of financial conditions” - Bank of Canada press release 1 June 2010.

This normalisation of monetary policy, coupled with the central bank’s current position that “over time, some modest withdrawal of monetary policy stimulus will likely be required, consistent with achieving the 2% inflation target”, has led some to characterise Carney as being relatively hawkish. As a result, some commentators fear that the Bank of England will become more focused on its inflation target once again – which they have clearly missed in recent years. This suggests a reduced likelihood of more stimulatory policies, and with less prospect of more Quantitative Easing, sterling upside potential is increasing.

This is of course nonsense. The BoC isn’t exactly taking a hard line on the situation, given the relatively strong performance of the Canadian economy. Indeed, we would suggest that pretty much all other G10 central bankers would take a similar view in terms of their assessment for Canada if they headed the BoC. In any case, the Bank of Canada has highlighted its flexibility and willingness to use unconventional policy tools such as balance sheet expansion and innovative use of language. Given the UK is in a worse position than Canada, it is likely that a Carney-led BoE will continue to be willing to use non-standard policy tools and it is highly unlikely that we will see a shift in policy.

Can Carney Turn the UK Around?
First off, it is important to remember that Mark Carney was not in charge of the BoC in the lead up to, and the initial stages, of the global financial crisis. Indeed, the reason that Canada has performed so strongly is largely because of sound economic fundamentals and strong banking regulations that were in place well before he joined. These included leverage caps, broad deposit and mortgage insurance and strict standards on lending. This meant that Canada didn’t experience the worst excesses of the credit binge, asset bubble and subsequent banking bust that have crippled other developed market economies. As a result, Carney didn’t have to cope with the threat of bank runs and bank failures and a breakdown in the domestic monetary transmission mechanism that has been experienced in Europe and to a lesser extent in the US.

 

Figure 1: Canada Clearly Outperforming the UK

Asia's Total Net Oil Imports vs Crude
        Brent Oil Price

Source: EcoWin, ING

 

Figure 2: While Canada is Doing Better on Inflation Too

Asia's Total Net Oil Imports vs Crude
        Brent Oil Price

Source: EcoWin

Because of this, the actual downturn in economic activity was far less severe than experienced elsewhere. It is also important to remember that Canada benefited from the commodity price rebound that came through in 2009, which helped to boost the mining sector (and tax revenues), while newfound energy resources have also been a boon, helping to provide a partial stimulus not experienced elsewhere. In this regard, Canada’s fiscal position has outperformed, meaning that there hasn’t been the need for aggressive austerity, which would have weighed on the economy and necessitated offsetting monetary policy support. As a result, we have seen large employment gains in Canada, with 3% more people employed than before the pre-recession peak.

 

Figure 3: Employment Levels Relative to Pre-Recession Peak

Asia's Total Net Oil Imports vs Crude
        Brent Oil Price

Source: EcoWin, ING

 

Figure 4: Consumer Confidence

Asia's Total Net Oil Imports vs Crude
        Brent Oil Price

Source: EcoWin

Canada has also been helped by what it exports and to whom. Indeed, over 70% of exports go to the US, with the next highest export destination, the UK, accounting for just 4%. Amazingly, this is more than Canada exports to the other 26 EU countries in total! Given the US is growing and half of UK exports go to Europe, it is not surprising that Canada is outperforming on the trade front. Moreover, with the US housing market picking up, the supply of raw materials from Canada, particularly lumber, will continue to buoy the exports in our view.

 

Figure 5: Export Breakdown

Asia's Total Net Oil Imports vs Crude
        Brent Oil Price

Source: HM Revenue & Customs, StatCan

 

However, there is some concern that Canada may now be experiencing what the likes of the US, the UK and Ireland went through just a few years before. A sustained period of low interest rates has helped fuel credit growth and house prices. Indeed, OECD calculations show that Canadian house price to rent ratios are at record highs, suggesting the possibility of a bubble, while the indebtedness of the Canadian household sector is approaching UK levels. This has prompted some to comment that Carney is leaving the BoC at just the right time.

However, the fact that the Canadian banking sector is far less leveraged than in most other countries should mean the systemic risks are smaller and any bursting of the “bubble” would be far less painful. Indeed, Canadian bank assets are around 140% of GDP, whereas at its peak, The Royal Bank of Scotland (RBS) alone wasn’t far off from this figure relative to UK GDP, with a UK bank sector total figure that was well in excess of 500% of GDP.

 

Figure 6: Household Liabilities % of Disposable Incomes

Asia's Total Net Oil Imports vs Crude
        Brent Oil Price

Source: EcoWin, OECD

 

Figure 7: Deviation of House Price to Rent Ratios From Historical Averages

Asia's Total Net Oil Imports vs Crude
        Brent Oil Price

Source: OECD, Bank of England

Of course, Carney is taking on a broader role than that being vacated by Mervyn King. Not only will he be in charge of monetary policy, but also financial policy and banking supervision. His experience of the Canadian system will be of use, as will his time as the chairman of the Financial Stability Board. However, it is a daunting role, given he will have far more people to placate and battles to fight – whether being an “outsider” is a benefit or not is difficult to say.

Nonetheless, the UK’s banking system is moving on to a healthier footing, albeit gradually. UK bank lending as a percentage of deposits has fallen from 135% in 2007 to 105% currently, while the UK’s exposure to peripheral Europe is falling. Exposure to peripheral European sovereigns is down 49% since 2010, while direct banking exposure is down 33% and private sector exposure is down 11%, which gives a total exposure currently of £170bn. This is equivalent to 72% of core Tier 1 capital, versus 160% in France. We believe his time at the relatively cautious Canadian central bank will keep these trends in place.

In terms of the direct impact on monetary policy, it is quite clear that Bank of England officials are focusing more on the Funding for Lending Scheme rather than further quantitative easing to try to loosen tight credit conditions. We don’t see this shifting under Carney, nor do we see the prospect of rate hikes happening any sooner under Carney relative to King – remember the Monetary Policy Committee is one member, one vote. Indeed, it may be the other way round with Carney recently emphasising his flexibility by talking about more unconventional policy, if required.

In an 11 December speech, he spoke about the importance of policy language and other economic targets rather than purely focusing on the BoE’s current policy of inflation targeting. Similar to discussions going on at the Federal Reserve, he talked of the merits of numerical targets for unemployment and commitments to keep policy ultra-loose. Indeed, the key passage stated that if “further stimulus were required, the policy framework itself would likely have to be changed”, adding that “adopting a nominal GDP level target could in many respects be more powerful than employing thresholds under flexible inflation targeting”. For sure, several BoE members will oppose this, as they fear the impact that shifting the target would have on the Bank’s credibility.

Nonetheless, given the UK’s poor GDP performance, this is likely to have been something Carney discussed with Chancellor Osborne, and as such, it opens up the possibility that the BoE could pursue even more aggressive policy actions. This would involve further QE and an expansion of the funding for lending scheme along with more explicit language on how long Bank Rate may stay at ultra-low levels.

That said, with domestic confidence readings stabilising and encouraging signs on employment and consumer spending coming through, we may actually see some positive developments on UK growth. Indeed, external threats from the US fiscal cliff and Eurozone sovereign debt crisis are probably the biggest risks for the UK recovery right now, and if these fade, as we suspect, the economic environment could look somewhat different in seven months’ time, when Carney takes over as BoE Governor.

In terms of sterling implications, as members of the G7, both the UK and Canada are expected to maintain fully flexible foreign exchange regimes. The BoC has kept a reference to the ‘persistent strength’ of the Canadian Dollar (CAD) in its official interest since December 2010. That said, under King’s stewardship, the BoE has on occasion appeared keen to encourage a weaker sterling. Most recently on 14 November, King said that the rise in the British Pound (GBP) ‘was not a welcome development’.

In overall terms, the direction of GBP is less about the personality at the top of the BoE and more about the outlook for the UK economy. Given his recent comments, it is clear that Carney would not refrain from easing BoE policy, if required. However, if we are correct in predicting a more conducive growth environment in 2013, it would be likely that the BoE has completed its policy easing before Carney’s arrival, meaning he joins at a time when GBP might look rather more appealing. If sterling has commenced an appreciation trend, this should more than offset any (unfairly garnered) hawkish tendencies that some suspect of the incoming BoE governor. At this point, we do not deem it necessary to alter our mid and end-2013 EUR/GBP targets from 0.78 and 0.80, respectively, on the announcement of Carney as the new BoE Governor.

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