Until late 2018 it was widely expected that interest rates would begin to slowly but steadily rise, with the Bank of England itself expecting so, however this has now faded.
In May, Kensington Mortgages capital markets and digital director Alex Maddox noted that markets were now only pricing in a slight rise from 0.75 per cent to one per cent at most within the next three years.
Speaking at the Local Government Association (LGA) annual conference, Carney noted that financial markets have instead begun pricing in cuts to the BoE base rate in response to increasing fears of a no-deal Brexit and the ongoing US-China trade dispute.
“Since the middle of last year, expectations of UK rates three years ahead have fallen by around half a percentage point and 10-year gilt yields are similarly lower,” he said. (See graph below)
He continued: “Over the past two months, markets have placed a growing weight on the possibility of No Deal, with the betting odds doubling to almost one in three.
“Financial market participants have marked down UK-focused equity prices, sterling and their expectations for Monetary Policy Committee (MPC) policy accordingly,” he added.
Two contrasting positions
Carney reiterated that given the exceptional circumstance associated with Brexit, the MPC would support the UK economy’s transition as much as possible, but there were limits to how much it could do.
He then set out the two contrasting positions which sees market pricing suggesting a greater likelihood of rate cuts.
“If Brexit progresses smoothly, we expect that the current heightened uncertainties facing companies and households will fade gradually, business investment will rebound, the housing market to rally, and consumption to grow broadly in line with households’ real incomes,” he said.
“This would accelerate economic growth, strengthen domestic inflationary pressures, and require limited and gradual increases in interest rates in order to return inflation sustainably to the two per cent target.
“It is unsurprising that the path of interest rates consistent with achieving the inflation target in this scenario differs from current market pricing of a lower expected path for Bank Rate given that the market places significant weights on both the probability of No Deal and on cuts in Bank Rate in that event.
“As the perceived probability of a No Deal has picked up, the levels of Bank Rate, Sterling and other UK asset prices in our projections have therefore become increasingly inconsistent with the smooth Brexit assumption in the MPC’s projection,” he added.