Don’t Fight the Fed and Don’t Combat Carney: Forward Guidance at the Bank of England

Mark Carney has really put his stamp of authority on the Bank of England (BoE). After just one month as the BoE’s new governor, he’s already shaking things up. At the latest meeting of the Monetary Policy Committee (MPC), he introduced forward guidance that would have been almost unimaginable  under the previous Governor, Mervyn King.

Here’s what Carney’s forward guidance looks like. The MPC intends not to raise their benchmark bank rate from its current level of 0.5% until the unemployment rate falls to a threshold level of 7%. This is subject to three caveats:

  • inflation is no higher than 0.5% above the 2% inflation target at the 18-24 month horizon
  • medium-term inflation expectations are contained
  • and the Financial Policy Committee (FPC) believes that an accommodative monetary policy stance doesn’t pose a risk to financial stability.

However, the threshold isn’t a trigger. The MPC won’t necessarily raise rates when the threshold is met – rather, they will “reassess” their guidance.  The MPC’s own forecast has unemployment above 7% until the second half of 2016, suggesting that rates will remain at current levels for the next three years.

The decision to provide forward guidance didn’t come as a surprise to the market, having been heavily trailed since Carney’s appointment was first announced last year. In March, the Chancellor of the Exchequer announced that he had commissioned a review of how guidance could work in the UK – a pretty clear signal that guidance was coming the UK’s way. Certainly, Carney has the full support of the government when it comes to providing growth-friendly monetary policies.

Why is Carney’s decision to introduce forward guidance so groundbreaking? Firstly, it’s not the majority opinion – it comes despite the reluctance of Carney’s fellow MPC members. Secondly (and the reason why there has been reluctance amongst the MPC), inflation in the UK is currently above the 2% target and has been for much of the past 10 years. Providing forward guidance at this juncture, therefore, puts the MPC at risk of losing its inflation credibility.  In addition, the UK economy is showing strong signs of recovery. True – as Carney said on Wednesday – the UK is in the midst of its slowest recovery on record and the level of GDP is still below its pre-crisis peak. Things are looking up though. In July, the UK PMI manufacturing index rose to the highest level since March 2011. Meanwhile, the PMI services index rose to 60.2 in July – the highest since December 2006 and a level surpassed only once in the past 15 years.

So why the decision to introduce forward guidance? As I’ve already described in previous posts (on the ECB here, and on the Reserve Bank of Australia here), the aim is to reduce uncertainty about the future path of policy and reassure consumers and businesses that rates will stay low for an extended period. The idea is to prevent the inevitable rise in expectations that would come as the economy recovers and – as we have already seen – as the U.S. gears up to reduce quantitative easing.

Rather than pushing bond yields lower on the day of the announcement, 2-year and 10-year gilts yields ended the day a few basis points higher. The early market reaction could be classified as either a bit of a disappointment or as “Yeah, but so what?” The market seems to be attaching more weight to the recent stronger economic data and is questioning whether or not the UK’s economy really needs such forward guidance.

In addition, the market may be questioning the caveats that came with the forward guidance. After all, the rules are open to interpretation. For example, how will inflation expectations be judged? A rule like this is difficult to pin down since it doesn’t seem to be tied to any particular measure of inflation expectations.

How will the FPC judge whether or not monetary policy is posing a risk to financial stability? In other words, the rules could be used as a “get out clause” should the MPC wish to raise policy rates without the unemployment rate having been breached.

More significantly, Britain’s inflation has been “above target” for much of the past decade and the BoE’s own 2014 forecast shows inflation only just on the cusp of the 2.5% “rule.” So it wouldn’t be impossible to see inflation forecasts drifting above 2.5% in just the coming months.

But, having introduced this radical change-up in UK monetary policy, Carney is hardly going to go down without a fight. He’ll only have this one chance to prove he is no damp squib, so if gilt yields fail to fall meaningfully from here, expect the new governor to find a way to force them down.

 

 

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