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Markets and central banks collide over forward guidance

CONCERNS over the Federal Reserve’s tapering of its asset purchases have unsettled the markets since June. The nervousness has intensified, as the presumed September deadline for starting the operation drew nearer. Equity markets in the US and Europe are 2% to 3% below their August highs. Fears over the impact of a possible military action in Syria have added to the anxiety.

But the key change in the situation is that bond yields, though still low by historical standards, have risen sharply over the last few months. Ten-year Treasury bonds have touched 3% early in September, almost double their 1.6% level at the end of April. Yields on German bonds and UK gilts have also recorded very large increases. This implies that the markets now expect official interest rates to start increasing much earlier than the central banks envisage.

The failure of Fed chairman Ben Bernanke and other central bankers to persuade the markets that their timetable is realistic has caused anxiety. The next Fed chairman, due to be appointed soon, will face major challenges. The turmoil has so far mainly hit major emerging economies. India, Indonesia, Brazil, Turkey and South Africa have all experienced large speculative capital outflows, their currencies have fallen sharply, and some have been forced to adopt emergency measures. 2013 and 2014 growth forecasts for these economies have been downgraded. But China remains an island of relative stability, in the face of disorderly markets. Figures for August show a fall in inflation to 2.6% and an upturn in both exports and imports, supporting hopes that Chinese growth will improve slightly in the third quarter of 2013.

In their forward guidance, the US Fed and the Bank of England have stressed that they expect official interest rates to stay at their current very low level at least until after the middle of 2016. But the markets now predict a much earlier date for official rates to start increasing, possibly the final months of 2014. The ECB, although less precise in its forward guidance, is also finding it difficult to persuade the markets that rates would stay low for a long time. The central banks fear that abrupt changes in market expectations may lead businesses and consumer to anticipate premature rate increases, and this could damage fragile economic upturns that are now gathering some momentum.

In the ongoing battle between the markets and the central banks, both sides are exaggerating. Bernanke and his colleagues are right to point out that it is wrong to confuse tapering with tightening, and the markets may be over-reacting. Overall, recoveries are mediocre rather than strong, even in the US, which is now acting as the world’s locomotive. On present trends, it is unlikely that official rates will start rising next year. But the markets are right to question the official view that rates will stay at current levels until the final month of 2016. The most plausible estimate is that the first increase in rates will occur some 9-12 months earlier than the central banks are predicting.

Major drivers
US housing remains a major driver of the recovery. Home prices rose 12.1% in the year to June 2013, only marginally below the 12.2% annual increase in May, which was the largest gain since March 2006. Rising house prices, and the creation of more jobs, improve confidence and make people feel richer. But there are worrying signs that the US housing market is starting to slow. Higher mortgage interest rates, which have moved up in line with bond yields, are starting to restrain home sales and inhibit the refinancing of transactions. The slowdown is likely to continue as mortgage rates rise further. This will not derail the US recovery, but an important economic engine will become less forceful.

US GDP grew at an annualised rate of 2.5% in the second quarter of 2013, up from an initial estimate of 1.7%, mainly due to a large revision to the trade figures. The US created 169,000 jobs in August, up from 162,000 in July, but less than the expected increase of 180,000. The unemployment rate fell to 7.3% in August, from 7.4% in July, but this was mainly because fewer people were looking for work. Overall, the recent GDP and job figures point to a middling US performance, with growth forecast at only 1.7% for 2013 as a whole. This is low by historical standards, but sufficiently positive to support expectations that the Fed will go ahead with its plan to start tapering soon its asset purchases.

After six consecutive quarters of negative growth, eurozone GDP returned to positive territory in the second quarter of 2013.

The upturn was weak, only 0.3%, and economic performance is still much weaker than in the US. In full-year terms, 2013 will still see negative eurozone growth of 0.5%. But there are realistic prospects that modest GDP growth will continue in the second half of 2013, and will strengthen gradually in 2014. The long eurozone recession has very probably ended, but serious threats persist. Greece is likely to need a third rescue plan, Portugal may require further support, and there is still no agreement on creating an effective banking union. The German election on 22 September provided an excuse for delaying tough decisions. But the ECB, in spite of its stabilising influence, may find it difficult to avoid the eruption of renewed turmoil in the next few months.

The UK, after lagging for a long time behind all the G7 economies other than Italy, has emerged in the unusual position of “star performer”. GDP growth in the second quarter of 2013 was revised up from 0.6 to 0.7%. Business confidence is rising, and early indicators suggest that UK growth will remain relatively strong in the third quarter of the year. These welcome developments are creating problems for Mark Carney, the new Bank of England governor. Carney’s forward guidance states that the MPC intends not to raise Bank Rate from its current level of 0.5% at least until the unemployment rate has fallen from 7.8% to 7.0%, and assumes that this threshold will not be reached at least until the third quarter of 2016. But the markets, probably incorrectly, assume that this may happen two years earlier.

David Kern of Kern Consulting is chief economist at the British Chambers of Commerce. He was formerly NatWest Group chief economist

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