Potential Political Upheaval, Uncertain Economy a Challenge for BoE

The Bank of England (BoE) and the U.S. Federal Reserve are the two major central banks currently sharing the lead on expected interest rate hikes. Not long ago, it was the Old Lady alone that had investors guessing as to when a rate hike would be announced, while the Fed struggled to successfully communicate with the markets after new Chair Janet Yellen took the reins.

Criticized for not being able to call the U.K. recovery in time, the BoE was criticized, but Governor Mark Carney promised a shakeup to improve the accuracy of the bank’s economic growth forecasts. Though changes were made, the new team would face different economic conditions. Carney turned dovish recently influenced by global economic weakness, low inflation in the U.K., and the eurozone’s abysmal economy. The BoE’s Chief Economist Andrew Haldane admitted to the press he was gloomier about the economy.

The pound was sensitive to the change in macroeconomic conditions, and the pessimistic tone from the central bank did not aid the currency as it lost ground to the U.S. dollar. Market opinion subsequently turned and bets are now on the Fed to announce a rate hike before the BoE.

Although the United Kingdom’s economy has slowed, the situation is not a dire as that which Europe and Japan are facing. The threat of deflation looms over both economies as officials fight political battles that block much needed reform.

Economic Growth Limited by European Union Exposure

Housing was one the biggest risks Carney flagged as a threat to the U.K. economy. The government had previously put in place a program called “Help-to-Buy” that involves using public funds to boost home ownership. The program has been a success in getting first-time buyers into the real estate market, but a cause for concern for policymakers, especially if they see a rate hike that could drive mortgages under water. The scheme boosted house prices, but upon closer inspection, it seems to be concentrated entirely in London. There is some good news: the real estate market slowed down this month, and that could make it easier for the central bank to raise rates with confidence.

Inflation in the U.K. is finishing the year at a rate of 1%, the lowest in 12 years. The commodities glut caused by remaining levels of production and lower demand has made energy more affordable, even as the winter season gets underway in Europe.

General Elections and Global Economy to Drive the Pound in 2015

Adding to uncertainty over the fragile state of the global economy, the United Kingdom will have what some analysts are calling the closest federal elections since 1945. The BoE will probably await the outcome of the electoral process next May before announcing any rate hike. The rise of the right-wing U.K. Independence Party (UKIP) will add a new wrinkle to the usual two-leading party system. The Labour and Conservative parties cannot ignore the rising anti-European Union sentiment that has fueled the rise of UKIP, and will add to the debate around stimulus versus austerity that is playing out around the world.

Central Bank Shaken but Not Stirred

When Carney left the Bank of Canada (BoC), he was a certified central bank rock star. At the helm of the BoC, he oversaw the world credit crisis unfold, and he successfully steered Canada through the resulting storm. After Sir Mervyn King’s retirement there was little surprise (except for Deputy Governor Paul Tucker) when the central bank appointed a non-British citizen for the fist time. Carney joined the Old Lady with big plans but he needed to be a consensus builder and not the solo act he was in Canada, as the BoE decides based on a committee.

The shake up at the central bank has been mixed but positive overall. Out are the economists who missed the U.K. recovery and made the bank lose face. Also out are those whose duties included overseeing the Libor and FX markets as the world’s regulators centered their sights on manipulation that had gone unchecked. A new, more diverse group is now in place that will have a stronger bond with Carney than with past administrations. That will help him get that consensus he needs to steer the U.K. economy in the direction he thinks it should go.

The recent changes to the BoE’s communication strategy are aimed to bring the central bank more inline with the fast pace of the financial markets. It will be interesting to see if Carney and his team learned the lessons of 2014 and avoid making the same mistakes.

The challenge is growing rapidly. Though world’s apart economically, the situation in Europe and Japan did not improve in 2014 despite inventive monetary policies, and even more outrageous verbal interventions. Meanwhile, the Fed continues to provide a solid pace that will end its lowest interest-rate environment on record. The BoE will probably follow the Fed, but the outcome of the U.K. elections, and the exposure to European headwinds will delay any expected rate hike from Carney and his team.