Forward guidance

The Bank of England launched its ‘forward guidance’ policy in August 2013.  The announcement was the first clear sign that the new Governor, Mark Carney, intended to make monetary policy more open and transparent – namely that well publicised unemployment figures will be used to provide significant and tangible evidence of whether macro-economic policy is working in general, and whether, specifically, monetary conditions will be tightened or loosened during Mr. Carney’s tenure at the Bank.

Of course, while the Bank of England’s brief has not changed – namely to achieve the inflation target of 2% while creating a stable financial environment – the acceptance that conventional monetary instruments failed to bring about sustained recovery following the financial crisis. This announcement clearly brought to an end the Mervyn King era.

As the Bank of England put it itself (Inflation Report, August 1st 2013) its forward guidance “should reduce the risk that, as the recovery gains traction, market interest rates rise prematurely and people worry excessively about early rises in borrowing costs. By so doing, it should help to secure a recovery of sufficient strength and duration to return output, employment and incomes to their full potential levels, consistent with medium-term price stability.”

The Bank of England has been at pains to state that the 7% unemployment figure is simply a ‘threshold’ and not a ‘trigger’ for a policy change. Indeed, the policy was updated in February 2014 as unemployment in the last quarter of 2013 fell to 7.1%. Despite the unexpected fall in the unemployment figures, the Bank estimated that there was sufficient slack in the economy to keep interest rates at 0.5%.

According to the Bank, slack exists within the labour market given that actual unemployment (at 7.1%) is still greater than what it believes to be the ‘medium-term equilibrium rate of unemployment’ (at 6% to 6.5%). The Bank further indicated that slack also exists because workers would prefer to work more hours as the economy grows, which, if true, will clearly dampen possible upward wage pressure. Falling unemployment also led the Bank to signal that it would consider a wide range of indicators, though still defending the use of an unemployment threshold. Unemployment, the Bank argues, is one of the least volatile indicators of economic activity, and is ‘widely understood’ as an indicator of economic well-being. Even when slack disappears and the economy returns to somewhere near its trend rate, interest rates are likely to remain at levels well below those prior to the financial crisis, given the Bank’s estimates of the existing output gap (at 1.5%).

Making various assumptions, the Bank expects that rates will rise to between 1% and 2% during 2015 and 2016. It is certainly not clear yet that the recovery will be sustained, or that it is ‘balanced’. Only when business investment and exports pick up substantially, and growth is less reliant on rising household spending and a savings run-down, will the recovery be regarded as sustainable and balanced.

Output gaps