British rate rise in 2014 less certain than market thinks

LONDON Fri Jun 13, 2014 12:17pm EDT

LONDON (Reuters) - A Bank of England interest rate rise before the end of the year is a distinct possibility after unusually hawkish comments from Governor Mark Carney - but it is perhaps less certain than financial markets now think.

Carney surprised investors late on Thursday by saying that rates could rise sooner than markets had previously expected, causing sterling to soar to near a five-year high against the dollar and interest rate futures to price in a rise this year.

The Canadian's comments were all the more unforeseen because he had seemed one of the more dovish members of the BoE's Monetary Policy Committee, concerned that robust growth should be on a more sustainable footing before rates went up.

In contrast to some past statements, he did not specify exactly what yardstick the bank would use to judge when to move.

Until Thursday, most economists had not expected rates to rise until just under a year's time. This was based on central bank forecasts last month which showed that an earlier move was not needed to keep inflation just below its 2 percent target.

A Reuters poll of 45 economists taken on Friday after the speech found most now expect a rate rise by the first three months of next year but only 10 see it coming late this year.

Britain's rapid growth has proved unexpectedly persistent over the past year, though there has been little change in the trend since a month ago, when Carney said the economy was only edging toward the time for a rate rise.

But while markets may earlier have underestimated the risk of an early rate rise, they could have gone too far in the opposite direction now, said UBS currency strategist Geoffrey Yu.

"When events like this happen, there is always a tendency to overshoot," he said - something he said might even apply to UBS's own new forecast of a November rate rise.

"At this point it's a matter of how soon is 'sooner', and no one has a good handle on that."

Carney would have been well aware of the likely market impact of the key line in his speech to London's financial community, yet much of the rest of his speech set out arguments against raising rates too early or too fast.

The economy still had capacity to grow without generating inflation, and wage pressures are notably weak, he said.

Carney also stressed households' high levels of debt compared to other countries, which makes Britons particularly vulnerable to rate rises.

Even before rates rise, almost one in seven mortgage holders spends more than a third of net income on repayments, according to the Resolution Foundation think tank.

The BoE will also keep a close eye on the impact of rate hike expectations on the strength of sterling.

The central bank said earlier this year that further strength in the currency could be an unwelcome headwind to British exports. Carney said on Thursday it would be unsustainable for Britain to use borrowing in an overvalued currency to prop up domestic growth.

TIMING VS PATH

Some economists argue that these caveats are more likely to slow the pace of rate rises than to delay their start.

"Carney is less concerned about the timing for the first hike than the path thereafter, which is likely to be gradual and limited," said Azad Zangana, a European economist at Schroders, which manages almost $500 billion of investments globally.

Some economists question whether to take BoE statements about longer-term intentions at face value, after a number of shifts in communication over the past year, culminating in Thursday's speech.

The commitment to a gradual pace of rate rises is almost all that remains from the so-called 'forward guidance' strategy which Carney brought in his tool-kit from Canada when he started as central bank governor a just under a year ago.

Originally the BoE committed to keep rates on hold until unemployment fell below 7 percent - something it forecast would take three years, but occurred within six months. In February, it said future rate moves would be linked to a much wider array of labor market measures.

"I think forward guidance in the conventional sense has been dead for a while," said UBS's Yu, arguing that February's change had already returned the BoE to setting policy based on a range of measures, as it had before Carney's arrival.

Other economists felt even that approach had taken a knock from Carney's speech on Thursday, as the sharp change in tone was not preceded by any similarly abrupt change in the data, which has proven robust for months.

"The speech did not give a clear justification for the switch," Allan Monks of J.P. Morgan wrote in a note to clients. "It feels as though the core message from the BoE is being somewhat detached from the data flow - which stands in contrast to Carney's comment that decisions 'will be data-driven'."

The governor said the BoE would look at a host of labour market, capacity utilization and pricing indicators to determine how slack in the economy was being used, adding that the economy's supply capacity was impossible to observe directly.

One possible reason for Carney's change in heart is that one or more MPC member may have voted for a rate rise at June's meeting - the voting records of which will be published on Wednesday, economists said.

A further complication for BoE rate-watchers is that three of the nine MPC seats will have changed hands between June and August, bringing in new policymakers whose views on the rates question are unknown.

Carney's record at the Bank of Canada certainly shows that he too can change policy fast when he wants to.

In April 2010 the BoC under Carney said it would be appropriate "to lessen the degree of monetary stimulus" as Canada's economy looked set to grow by 3.7 percent that year - only slightly faster than the 3.4 percent which the BoE forecasts for Britain this year.

Rates then rose in June, despite a previous commitment to keep them steady until the end of that month, and then twice more in the next three months - a distinctly non-gradual increase which no one expects in Britain, at least for now.

(Editing by Paul Taylor)

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