ADVERTISEMENT

BOE Has a Forecast Problem in Market’s Bets on Brexit Rate Cuts

Carney may find he has to disregard investors to send them a clearer message as he tries to reconcile his forecasts with market.

BOE Has a Forecast Problem in Market’s Bets on Brexit Rate Cuts
Mark Carney, governor of the Bank of England, delivers a speech at the Local Government Association conference in Bournemouth, U.K. (Photographer: Simon Dawson/Bloomberg)

(Bloomberg) -- Mark Carney may find he has to disregard investors in order to send them a clearer message as he searches for a way to reconcile his forecasts with the market.

Traders are increasingly pricing in a U.K. interest-rate cut as the prospect of a disorderly departure from the European Union increases, exacerbating the fallout from a global slowdown.

The problem for the Bank of England governor is that those market expectations are plugged into the BOE’s projections, which will be unveiled Aug. 1. Yet the bank doesn’t assume a no-deal Brexit because that’s not the government’s stated policy.

That makes for an unrealistic scenario in which Brexit is smooth but rates are cut, stoking the economy and pushing inflation above the BOE’s goal. Policy makers would, confusingly, have to then warn that rates need to rise.

Carney acknowledged the divergent outlooks in a speech in Bournemouth this month, and said officials will explore “how best to illustrate” the market “sensitivities” in August.

BOE Has a Forecast Problem in Market’s Bets on Brexit Rate Cuts

While policy makers have said they will continue to assume a Brexit deal in their forecasts until the government changes its policy -- a possibility given both candidates to replace Theresa May as prime minister have said they’d be willing to leave without a deal if needed -- one option is for the BOE to produce a separate set of forecasts for a no-deal outcome.

That approach might make policy makers uncomfortable, particularly if it’s seen as an unwarranted commentary on Brexit or the government.

The more likely alternative is for the bank to take a page out of its pre-Brexit playbook, when officials tried to strip the impact of market moves out of their projections. In May 2016, the month before the referendum, the BOE’s forecasts were based on an assumption to remain, and included an adjusted path for the pound that removed a large chunk of its recent drops.

A similar approach this time round could see forecasts conditioned on the assumption of a deal, with a significantly higher path for rates and the pound. If the bank’s calculations are similar to Bloomberg Economics’s model for a deal, which sees the market curve shift higher, those projections would provide a far more benign outlook for inflation.

Without any tweaking, the mechanical impact of market moves since May -- notably the downward shift in rate expectations -- will push the BOE’s inflation projection higher than the 2% target from the first quarter of 2020, according to calculations by Bloomberg Economics’s Dan Hanson. That’s a year earlier than previously expected.

Such a profile would normally draw a hawkish reaction from the central bank, where officials are already warning of limited and gradual rate hikes should their forecasts come to pass. That would risk a repeat of the response to the BOE’s May decision, when warnings that the current outlook for rates was “unequal” to officials’ remit fell on deaf ears.

The BOE may also lower its inflation projection by downgrading the outlook for U.K. growth in the wake of increased risks from Brexit and global trade tensions. But whatever solutions policy makers engineer, Carney will still have a communications headache at at time when other central banks are turning dovish.

To contact the reporter on this story: David Goodman in London at dgoodman28@bloomberg.net

To contact the editors responsible for this story: Paul Gordon at pgordon6@bloomberg.net, Brian Swint, Jill Ward

©2019 Bloomberg L.P.