To say that last week’s Bank of England announcement of explicit forward guidance on policy rates was met with skepticism in the financial markets is an understatement, as seen by the subsequent sharp rise in the British pound and a massive selloff in bond yields. Policy pundits crow that Mark Carney has scant power within the BoE. Others believe Canadian central banking will not work in the U.K.
What investors are overlooking, however, is that the U.K. has not hired a Canadian-style central banker – it has hired an investment-bank-style chief with all the backroom dealing and sharp elbows that that entails.
Much of the market disdain centres on Mr. Carney’s ability to control the head-strong monetary policy committee, where he is but one vote at the table. In the past, MPC members were notorious for divergent views, often reflected in split voting counts. In addition, many committee members have previously expressed doubt about the effectiveness of forward guidance, which is the cornerstone of Mr. Carney’s new monetary policy for the U.K. Indeed, former BoE governor Mervyn King was outvoted by the committee at the last MPC meeting he chaired. That had to hurt.
On the face of it, Mr. Carney had a much easier time at the helm of the Bank of Canada since the act governing Canadian monetary policy gives the governor sole control over policy settings. Even so, Mr. Carney had a heavy hand in shaping the BoC leadership during his tenure, filling many governing council and senior adviser spots with officials holding similar views to his own – some even plucked from the ranks of the investment banking industry.
Assembling a team loyal to the leader is a classic tactic dating back 600 years to Renaissance Italy and the time of Machiavelli. And Mr. Carney honed this type of leadership skill during his 13-year tenure at Goldman Sachs.
In his political tome The Prince, Machiavelli counselled that any new prince must consolidate power by eliminating the bloodline of the previous prince. Thankfully, investment bankers use a more bloodless style, but the fact is when a new investment bank CEO comes to power, there is inevitably a rash of departures amongst the previous leadership team through not-quite-voluntary retirements and resignations.
Mr. Carney is already reshaping the BoE hierarchy, as evidenced by the announced retirement of senior deputy governor Charles Bean and the early resignation of Mr. Carney’s chief rival for the top position, Paul Tucker. More departures may soon follow if committee members continue to resist Mr. Carney’s will, and investors should start to expect fewer dissenting votes on the MPC.
Such tactics are not new to central banking. Former U.S. Federal Reserve chairman Alan Greenspan was a master of Machiavellian tactics to maintain power over the policy vote. Dissenting votes against the chairman within the ranks of the Federal Open Market Committee were rare during his tenure. There was a tacit understanding among committee members that no more than two votes against Mr. Greenspan would ever be tolerated at any given FOMC meeting.
What will be the consequence of Mr. Carney’s style of central bank stewardship at the BoE? Canada’s own experience with forward guidance introduced by Mr. Carney produced decidedly mixed results. In April, 2009, the BoC announced a commitment to keep rates at 0.25 per cent until the end of the second quarter of 2010, on the condition that inflation and expectations remained well-contained throughout that period.
Mere months after the announcement, the BoC was feeling hamstrung by the commitment. The prospect of low rates for the proceeding 15 months almost immediately brought a surge of credit growth as households snapped up houses, motor vehicles and refrigerators with abandon and chartered banks salivated over high profits reaped by the cheap costs of financing those loans.
By late 2009, the BoC was already becoming nervous as it was already time to start raising rates from emergency levels, but did not act. Employment growth was averaging 40,000 per month by December and inflation consistently came in stronger than predicted. Yet the BoC waited another agonizing 4 months before tightening policy, in April, 2010, when inflation surged unexpectedly above the 2-per-cent target.
This first experience Mr. Carney had with forward guidance is likely the reason why last week’s BoE announcement added a third condition to the rate commitment: If “the Financial Policy Committee (FPC) judges that the stance of monetary policy poses a significant threat to financial stability that cannot be contained by the substantial range of mitigating policy actions available to the FPC… .”
It was during the latter months of 2009 as credit surged, and the end of the commitment period was still almost a year away, when Mr. Carney first drew the link between monetary policy and macroprudential policy (financial market regulation). In a speech in August, 2009, at the Fed’s annual Jackson Hole symposium, Mr. Carney argued changes in financial regulation could be used to supplement monetary policy when the blunter tool of interest rates was not appropriate for the economy as a whole. Guided by Mr. Carney’s advice, the Finance Minister tightened mortgage guidelines in an attempt to calm Canada’s rapidly overheating housing market.
Over the course of the BoE’s forward-guidance period, Mr. Carney may face similar dilemmas of surging credit and still fragile economic fundamentals, but the explicit introduction of macroprudential tools as a monetary policy lever may allow forward guidance to linger even longer. As such, the selloff in the U.K. bond market, particularly the front end, seems likely to last.
Sheryl King is an independent macroeconomic strategist with more than 20 years experience in the international financial industry and central banking.