Mark Carney’s motivation for introducing forward guidance was to persuade consumers and businesses to spend more by convincing them that Bank rate would remain at 0.5% at least until after the 2015 general election. His latest policy innovation will allow him to continue to pursue this goal.
The MPC’s first guidance effort was time-based, in the form of a statement in the July 2013 decision press release that the market-implied future path of Bank rate was “not warranted by the recent developments in the domestic economy”. This was swiftly brushed aside by markets as much too weak.
The second, more serious initiative was the commitment in August 2013 to defer an interest rate rise at least until the unemployment rate fell to 7.0%, a condition Bank of England economists confidently expected not to be met for three years. This was admirably clear and Mr Carney cannot be blamed for the Bank staffers’ woeful forecast. He has, however, learnt his lesson.
Forward guidance 3, therefore, provides Mr Carney with maximum wiggle room by: 1) giving a central role to the unobservable “output gap”, the Bank’s estimate of which can be manipulated to suit policy objectives; and 2) setting central expectations for a number of other variables that – he thinks – are unlikely to be challenged sufficiently to force an early rate rise.
The Bank has pronounced that the output gap is “about 1-1.5% of GDP” but has provided no calculation details, no history of its measure and no information about its estimate of current potential output growth – the latter would allow markets to infer changes in the gap as new GDP data are released. It has, in other words, given itself maximum flexibility to revise its assessment to suit the MPC’s policy judgement.
The new forecast, meanwhile, includes central expectations that: 1) unemployment will fall by a further 0.5 percentage points by the third quarter of 2014; 2) average earnings growth will pick up from 0.9% currently to about 2% by the same date; and 3) productivity expansion will revive only to about 1% by then. These judgements imply a high hurdle for the MPC to be surprised sufficiently to tighten policy this year.
Markets have interpreted the vagueness of the new guidance as increasing the probability of an early rate hike. This vagueness, however, is Mr Carney’s strength as he seeks to continue to postpone action.
The Achilles’ heel of the new policy is inflation. The MPC is unlikely to raise rates soon, even with super-strong growth and a further unemployment collapse, if the headline CPI rate remains at or below the 2% target, as the Bank predicts. Investors should expect an early rate rise only if they share the view here that recent inflation relief is temporary.