UK inflation report: guidance from the blind

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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.

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  • Anonymous

    “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.” Quite so, and very well put. In the press conference after the February Inflation Report was released, Copycat Carney told Chris Giles of the Financial Times: “the first phase of guidance, as you know, Chris, wasn’t time-contingent.” However, it really was. What was announced in August was time-contingent guidance, keeping the bank rate where it was until after the 2015 election, tarted up to look like state-contingent guidance.

    Mr. Ward is being much too generous in saying that Governor Carney cannot be blamed if the Bank of England’s forecasters didn’t forecast very well. He should surely have known that they had a spotty record when he took the job. Anyway, his position was that the unemployment rate was an acceptable measure of slack in the economic and that 7% was the appropriate threshold rate. If he really believed that when he said it (obviously he didn’t) there was no reason for him to jetisson his Made-in-USA monetary policy.

    Andrew Baldwin

  • David Lilley

    Simon,
    You are always correct. Your methodology in predicting output growth and the future path of inflation are good providers of the benefits of time travel/ gold. I use the term gold because the first thing a time traveller would collect is the Lotto jackpot.
    Your analysis above indicates that the future path of interest rates will be determined by the future path of inflation. And you will be correct. You have refrained from being bold and saying this will be in November 2014 or some other date. You have previously been astontishingly bold.
    When we put on 1m jobs whilst GDP was flatlining for three years none could explain. But you said that the economy must be improving. When others wrong-footed the BoE with talk of a triple dip you boldly stated that GDP would be 2% in 2013 when the OBR and the IFS and the rest were talking about 0.6%/0.8%. When the Governer of the BoE introduced the 7% target for unemployment on the 7th August 2013 you immediately pointed out that we would achieve this in early 2014 and not late 2016. You then reduced this to the end of 2013 and we hit the target in October 2013 on a monthly count.
    I do hope that Mark Carney reads your posts.
    In November 2013 we were putting on jobs at 20k per month, then 40k and then 60k. In late November 2013 Mark was telling the US that we were creating jobs at the rate of 60k per month and yet we were only one fifth of their population. He would have made a bigger impact if he had been aware that we were actually putting on jobs at the rate of over 90k per month in the three months prior to his speech in New York. We are currently putting on jobs at the rate of 100,000 per month. Our economy grew 3% in 2013 after expected revisions compared with a trend of 2.43%. An observer might call it a boom.
    I watched the whole of the BoE presentation and there was only one negative statement; “four quarters of consumers built growth does not spell a sustained recovery”. Yet this was the only extract from the presentation presented by the BBC on the 6pm News. There was no mention of the BoE revision of 2014 growth from 2.8% to 3.4%.
    We have had forward guidance since 2011. Ben Benancke and Mervin King advising that rates will remain low for two years and then they further extended this by a year to 2014. We just didn’t have the terminology “forward guidance”.
    My bottom line is that it is good that the BoE is returning to looking at the whole picture and the date of the election doesn’t enter into their picture.

  • Noo 2 Economics

    “My bottom line is that it is good that the BoE is returning to looking
    at the whole picture and the date of the election doesn’t enter into
    their picture”. Are you being sarscastic David?