Forward Misguidance

A bus parked in front of the Bank of England. The banner doesn’t necessarily describe new Governor Mark Carney’s forward guidance. Photo by Oli Scarff/Getty Images.

The FTSE All-Share had a rough day Wednesday (August 7), and if you believe the headlines, it’s all because new BOE Governor Mark Carney botched his first attempt at “forward guidance,” failing to convince investors the bank rate will stay ultra-low for the foreseeable future. The problem, they say, is he left too many get-out clauses, giving investors little to go on. To me, though, the problem rests on the basic assumption central bankers’ words are important. In my view, they’re not—and investors shouldn’t base decisions on banker-speak alone.

Carney’s statement was widely received as a major BOE policy shift, but in reality, it was nothing of the sort. He said the same thing officials have said for months—the bank rate will stay near zero and the BOE’s balance sheet won’t shrink a ton until it makes sense to shift course, either because the economy has plenty of steam or inflation looks dicey. The only difference now is policymakers’ attempts to tie a rate hike or asset sales to specific developments. Now, we know monetary policy won’t change until unemployment falls below 7%, unless inflation forecasts breach 2.5%, medium-term expectations are no longer “sufficiently well-anchored” (whatever that means) or the BOE sees “significant threat to financial stability.” Translated: The bank plans to tie interest rate policy to unemployment, but it probably won’t.

This largely mirrors the US Fed’s forward guidance—which makes me wonder why the BOE thought it helpful. Forward guidance, despite its benign intentions, is as much a potential negative as it is a positive. Investors have known the Fed’s general criteria for a rate hike for months—yet folks seem less clear on the Fed’s intentions today. Compounding matters, the BOE’s guidance rests on its own forecasts—forecasts the BOE itself admits have been worse than peers in recent years (this late-2012 independent review has a full indictment). Perhaps Carney can help shore up some of these forecasting foibles, but for now, it’s little wonder markets seem to disregard the BOE’s current expectations.

Currently, unemployment is 7.8% and inflation is 2.9%. The BOE expects 7.1% unemployment by Q3 2016 and 2.0% inflation over the next two years. Markets are smart. Even in the UK, where unemployment is more persistent than the US, it shouldn’t take over three years for joblessness to fall by 80 bps—an increase of about 750,000 jobs, adjusting for population changes. The UK has added about 925,000 jobs over the past four years—and that’s with anemic economic growth. With growth now accelerating, another 750,000 new jobs should come more quickly. Investors get this, hence the market could be pricing in a swifter rate hike—maybe sometime in 2015. Perfectly normal market behavior.

Except in this twisted environment where many folks (wrongly) believe low rates and a fat central bank balance sheet are the only things driving stocks, this normal market behavior is somehow bad. Carney, like Ben Bernanke, understands investors just want some reassurance their monetary morphine drip won’t vanish. So he’s trying to give it to them—to boost animal spirits, if you will. And investors “betting on” earlier rate hikes aren’t cooperating—never mind that for every investor betting rates rise early, a counterparty is betting they won’t. The BOE’s beef seems to be with free markets, not individual investors’ decisions, and it’s misplaced. Time and again, history has shown the market’s invisible hand would chart a much smoother course than any group of monetary policymakers, and chances are markets can better gauge when a rate hike is appropriate than the BOE can.

But the biggest problem with forward guidance, in my view, is its impact on investor behavior. It encourages investors to see things incorrectly—which can lead to some big portfolio mistakes. Central bankers’ words mean diddly-squat—actions are what matter, but investors focusing on forward guidance lose sight of this. Equally problematic, they over-focus on rate hikes. Rising rates aren’t inherently bad (or good) for stocks. But bad monetary policy decisions are, and forward guidance doesn’t decrease the likelihood of boneheaded moves down the road. Nor does it help investors assess the likelihood of policy errors, given conditions and plans change. Those who invest by central bankers’ words alone have a huge blind spot and could easily miss significant opportunities. Or, they could make knee-jerk, short-sighted portfolio moves—almost never a winning tactic. If an investor acted on Carney’s words today, they might decide the UK economy is too weak to merit owning UK stocks—even though the UK’s market fundamentals look increasingly favorable.

Hence why investors shouldn’t put much stock into what central bankers say, no matter how explicit they claim to be. To stay ahead of the game, ignore the central bank chatter, and keep fundamentals top of mind.

(Hat Tips: Akash Patel, Todd Bliman)