News Column

Carney's fancy interest rate policy undone by events: Amid falling unemployment the Bank may weigh up other indicators - as the ECB does - before raising interest rates, writes Larry Elliott

February 10, 2014

Larry Elliott

Mark Carney has some explaining to do on Wednesday. Last August, the governor of the Bank of England announced the arrival of a shiny new model for setting interest rates in the UK. Six months on, it needs running repairs.

When he arrived at Threadneedle Street, Carney decided to dispense with the old method of doing business whereby the nine members of the monetary policy committee (MPC) would decide each month whether to change the official interest rate and whether to create additional cash by buying government bonds under the quantitative easing programme.

Carney's view was that households and businesses needed more certainty than that process provided . He therefore announced "forward guidance", under which the Bank commits to holding interest rates at its ultra-low level of 0.5% into the future. The idea was that the security of low interest rates would encourage people to buy houses and persuade companies to invest.

Clearly, the Bank could not commit to keep rates at 0.5% for ever, so a framework was put in place so that everybody would know when a change in the do-nothing strategy was getting closer.

So, the Old Lady put unemployment at the heart of the system. Back in August last year, when the jobless rate was 7.7%, the Bank said it would not even start talking about raising interest rates until unemployment hit 7%. This pledge would only cease to be binding if the Bank estimated that inflation would be above 2.5% in 18-24 months time; if there was some evidence that the public had ceased to expect inflation to remain low; or if there was over-heating in the housing market that could only be dealt with by raising borrowing costs and not by specific measures to tackle bubble conditions.

Almost immediately, unemployment - which had been fairly steady for a number of years - started to fall like a stone. This may have been a simple case of Sod's law. It may have been the latest in a long series of forecasting blunders by the Bank. It may, more charitably, have been the result of forward guidance itself, with companies emboldened to take on more staff because they believed in Carney's commitment to allow the party to rock on well into the night without taking away the punchbowl.

For whatever reason, the initial forecast - that it would take until early 2016 for unemployment to hit 7% - has been overtaken by events. The latest unemployment figures cover the three months from September to November 2013 and they show the jobless rate at 7.1%. In the next couple of months, assuming the trend continues, the 7% threshold will be reached.

The City, businesses, those who have mortgaged themselves to the hilt to get on the housing ladder, all want to know what Carney does next. Rarely has a quarterly inflation report been more eagerly awaited.

Carney's predecessor, Mervyn King, was not (to say the least) a fan of forward guidance so, in theory, the governor could say that King was right and he was wrong. There is not much chance of that, and not only because it would make the new governor look a complete Charlie. Carney believes that the old policy would have damaged the recovery by fostering speculation about an early rise in interest rates, and that danger still exists.

So what does the governor do? Firstly, he will defend forward guidance. Despite the fact that the economy grew strongly through 2013, the City does not expect the first rate rise to come until around the time of the 2015 general election. Carney will say that without forward guidance, the markets would be expecting a toughening up of policy well before that, with the result that fixed-rate mortgages, overdrafts and business loans would already be more expensive.

But he needs a new way of communicating his intention to keep borrowing costs low; preferably one with a longer shelf life than six months. There are five options.

Option number one would be to stick with unemployment as the yardstick of how the economy is doing and simply lower the rate at which an interest rate discussion would be triggered. The Bank could cut the threshold to 6.5%, the level it thinks is consistent with keeping inflation stable over the medium term. This does not look like a serious possibility; at the pace unemployment is falling the MPC could be in the same position again within months. This would lack credibility.

A second way out of the predicament would be to choose a different measure (or measures) of how well the economy is doing. But the Bank chose unemployment because it thought the level of joblessness was a reasonable guide, if not a perfect one, to the amount of spare capacity in the economy. Broadly, the higher unemployment, the faster the UK could grow without generating higher inflation.

As the dole queues shrink, the spare capacity is used up, workers are in shorter supply and wages start to go up.

There are alternative yardsticks the MPC could have used, such as the rate of average earnings growth or the increase in nominal gross domestic product, which is the change in the monetary value of all the goods and services produced in the economy before inflation is taken into account. The problem is that both were looked at and rejected by the Bank last August.

Option number three is to switch to say that an increase in interest rates will not happen for, say, the next two years. Given the Bank's hopeless track record for forecasting, this would take chutzpah.

That leaves two options, which involve following the example of other central banks. The Federal Reserve in the US publishes a chart showing where members of its interest-rate setting committee think borrowing costs are heading.

The MPC has traditionally favoured coming up with a collective view and could in theory synthesise the views of all nine members to come up a central path for interest rates. The question, here, though, is whether the Bank would be able to communicate clearly what its thinking was.

By a process of elimination that leaves unconditional forward guidance, which is pretty much what the ECB does. Carney would say that the MPC is looking at a whole bunch of indicators and will start to talk about tighter policy when they are flashing amber.

On past form they will be flashing amber for some time before the Bank notices so that moment is some way off.


Mark Carney will present the Bank's inflation report on Wednesday

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Source: Guardian (UK)

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