Time progresses, and eventually ‘long’ is not such a long time away. Governor Mark Carney of the Bank of England (BoE) provided a wake-up call for the markets at his recent speech: the story has now changed. At least in the UK, rates will likely rise sooner than expected but may rise less quickly. “Low for long” has become a more imminent “less for longer”.
“Less for longer” does entail an earlier rate hike, but this is offset by subsequently hiking rates less quickly than would have been envisaged under the old “low for long” story. At first interest rates would be higher, but eventually, say in a year or two rates would be lower than previously expected (see chart 1) and they would converge more slowly to their equilibrium level.
Why did the Bank of England switch the story this way?
“Low for long” was a very strong communication tool when the recovery was subdued and interest rates were close to the lower bound. It allowed the BoE, and other central banks, to push down longer-dated bonds by convincing markets that short rates would remain very low for an extended period of time (and long rates are the accumulation of expected short rates). Now that the recovery in the UK has turned out to be surprisingly strong
Back in 2009 the UK was experiencing a very subdued recovery in both activity and employment that was not very different from that of the Eurozone (see chart 2). However, over the last year UK activity accelerated substantially and employment growth rose. And unlike the US, where unemployment was falling mostly because of people dropping out of the labour force and pushing down the participation rate, the UK had job growth that was faster than both the US and Germany. Perhaps the most important reason that the BoE wants to hike earlier is that keeping rates low for long while the economy is growing rapidly is fraught with risks. A strong job outlook and confident consumers combined with cheap borrowing could lead to more borrowing and an overleveraging of the economy. True, years of low interest rates have not resulted in excess leverage. As long as the economy was weak, households and firms remained cautious so there was little demand for credit. Now that the economic situation has improved demand for credit is returning. If borrowers have been promised rates that will be “low for long” they are likely to be even more willing to borrow. Extra leverage now would make the household sector more exposed to future interest rate hikes when they eventually occur. The resurgent UK obsession with housing could easily make this an issue for the BoE. House prices have been rising rapidly once again and many commentators suspect that this was a key motive behind the BoE’s more cautious stance.
Similarly, a releveraging could occur in the corporate sector. The BoE’s August 2013 Inflation Report highlights that bankruptcy amongst firms during the crisis has been much lower than in previous recessions. This is despite the recession being one of the worst in UK history. One of the key reasons has been that those firms have managed to survive on cheap borrowing. Rising interest rates could pose a threat to those businesses unless their fundamentals have improved enough in the meantime.
A “low for long” strategy amplifies these risks. Conversely, “less for longer” serves to remind households and businesses that rates can rise by bringing forward the first rate hike.
Having delivered this important message, it tries to balance the damage this could do to the recovery by being slower in raising rates thereafter. If it turns out that the recovery is in peril, the BoE can always switch back to keeping rates on hold until the economy picks up again. But if the recovery continues and even accelerates, the BoE can always choose to accelerate the pace of rate hikes but less than in a context of “low for long”.
If you think that the new commitment to “less for longer” sounds less like a commitment and more like a rough guide, then you would be right. The old commitment of “low for long” was meant to stimulate a recovery, and now that the recovery is here the commitment is less necessary.
Not to mention the simple fact that having changed one commitment, how credible is the next one?
Use of new macroprudential powers, such as constraints on loan-to-value ratios or the loan-to-income ratio, or increasing bank reserve requirements, could be used to deal with credit growth while still allowing the economy to benefit from low interest rates on the existing stock of debt and incentivising the corporate sector to invest more. The
BoE could stick to its new commitment to “less for longer” by using macroprudential policy to deliver any additional tightening. Given that this is the first time a central bank has begun exiting ultra-loose policy using a combination of both standard (interest rate) and non-standard (macroprudential) measures, it is likely to be a slow process that will require constant monitoring.
What does this mean for other central banks? The US Federal Reserve has long been committed to a “low for long” policy. Could the Fed also switch to “less for longer” if the US recovery becomes stronger? So far credit growth in US housing has been moderate, but the growth in commercial and industrial lending has been much faster. The latest set of projections from the Fed show only one member looking for the first rate hike in 2014, with the majority still expecting it by the end of 2015. Nonetheless, they could easily bring forward the first rate hike to earlier in 2015. The markets could end up seeing more of less for longerthe environment for monetary policy has changed.
