Investment Research General Market Conditions 12 December 212 Research UK NGDP level targeting in the UK don t ignore it On 1 July 213 the present governor of the Bank of Canada, Mark Carney, will take over as new governor of the Bank of England (BoE). Therefore, any comment from Mark Carney will be taken by the markets to be relevant for not only the Canadian markets, but also for the UK markets. From a UK perspective, Mark Carney s comments overnight seem highly relevant: If yet further stimulus were required, the policy framework itself would likely have to be changed. For example, adopting a nominal GDP (NGDP) level target could in many respects be more powerful than employing thresholds under flexible inflation targeting. This is because doing so would add history dependence to monetary policy. Under NGDP targeting, bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP. Carney is referring to a situation where interest rates are at the so-called Zero Lower Bound (ZLB). With interest rates close to zero, monetary policy cannot be eased further by cutting interest rates (if technical or systemic factors in practice rule out negative rates), but that does not mean that the central bank is out of ammunition. Hence, an option for the central bank stuck at the Zero Lower Bound would be to announce, for example, a target for the level of nominal GDP (NGDP). This is what Carney theoretically is suggesting. Central Banks at Zero Lower Bound 6 5 UK 4 3 2 USA Eurozone 1 8 9 1 11 12 Source: Reuters EcoWin, Danske Bank Markets UK is below pre-crises nominal GDP path 27, 26,9 ln(ngdp) ln(ngdp) 26,8 Nominal GDP 26,7 26,6 26,5 26,4 26,3 26,2 26,1 26, 2 4 6 8 1 12 Source: Reuters EcoWin and Danske Bank Markets 27, 26,9 26,8 26,7 26,6 26,5 26,4 26,3 26,2 26,1 26, Chief Lars Christensen +45 4512 853 larch@danskebank.dk Anders Vestergård Fischer afis@danskebank.dk Important certifications and disclosures are contained from page 4.
In the case of the UK and many other countries where the level of NGDP has dropped well below the pre-28 trend an announcement that the Bank of England is to bring NGDP back to the pre-crisis trend would therefore effectively be an announcement of significant monetary easing from the Bank of England. If an NGDP level target was combined with an announcement to undertake unlimited and open-ended quantitative easing to reach the target, the market and economic impact is likely be very strong. How the BoE would reach such a goal is uncertain. So far, the BoE has been one of the most expanding major central banks in terms of increasing its balance sheet. In the current Asset Purchase Programme, the BoE has been buying gilts of GBP375bn, now holding 34% of all outstanding gilts. Recently, we have also seen the FED signalling a more rule-based monetary policy. However, so far, we have not seen the full effect in market pricing partly due to mixed signals in communication and lacking consensus on what form the final rule will take. Obviously, Carney is not saying that the BoE will (or shall) do that under his leadership but his comments are nonetheless noteworthy. There are two reasons for this. First, contrary to the Bank of Canada, the BoE is at the ZLB so it is obvious that further monetary easing in the UK would have to involve looking at the BoE s inflation target directly or indirectly. Second, according to media reports, the UK government is open to discussing the BoE s monetary target and some cabinet members have even suggested that the BoE should introduce an NGDP level target. Carney s comments overnight therefore are likely to increase both market and media attention to this and as such it could easily become a market mover for the UK markets in coming weeks and months. Note also that the Bank of Canada under Carney s watch has been discussing implementing a price-level targeting, so Carney is very much at the centre of this debate. Expanding Central Bank balances 5 Index (1/1/28 = 1) 4 UK USA 3 2 1 Eurozone 8 9 1 11 12 Source: Bloomberg, Danske Bank Markets In our view, these signals from Carney could be the first baby steps in the direction of introducing an NGDP level target. The UK government has repeatedly stressed that its strategy to pull the UK economy out of the crisis is a combination of fiscal tightening/consolidation and monetary easing. The UK government is delivering on the first part through its austerity measures (though extended to 218 in last week s Autumn Statement). By introducing an NGDP level target, the BoE would commit itself to delivering on the monetary easing part. One option is of course that it could introduce NGDP level targeting as a operational tool, but another more radical option might simply be that the UK government would change the legislation to change the BoE s mandate from inflation targeting to NGDP level targeting. The second option obviously would be the most potent solution. It should be stressed that all this is speculation but given Carney s comments and the obvious interest in NGDP level targeting among certain UK government ministers and officials, it would be wrong from a market perspective to ignore the discussion about a possible change to the UK monetary policy set-up. What to buy and sell if the BoE introduced NGDP level targeting If we hypothetically assume that the UK government and BoE tomorrow announce that the BoE will start undertaking unlimited quantitative easing to bring back the level of NGDP to the pre-crisis trend level then the implications for the UK economy and markets seem pretty obvious. First of all, this would be a significant boost to domestic demand in the UK economy and therefore likely raise (real and nominal) GDP growth and reduce unemployment. BoE Asset Purchase Programme 4 GBPbn 35 3 25 2 15 1 5 9 1 11 12 13 Up to 5y 5-1y 1-15y 15y+ Source: Bank of England, Danske Bank Markets Second, higher growth and inflation expectations would obviously increase long-term UK bond yields and the yield curve would be likely to steepen significantly. 2 12 December 212
An aggressive QE programme would put the BoE back as a powerful buyer of gilts, where it so far primarily has been buyers in the 5-15 year segment (68% of all purchases). Third, with the BoE announcing a stepping up of monetary easing, the British pound would be likely to take a significant beating, which on its own would help UK growth (see also our Top 1 trades for 213, from 5 December 212, where we recommend being short GBP against NOK). We think these trades are quite obvious. However, it should be stressed that neither the UK government nor Mark Carney has endorsed NGDP targeting. Therefore, it is in no way a given that the markets will start to price in NGDP targeting now. However, it is our expectation that the discussion will gain momentum, which in itself could become market moving. 3 12 December 212
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