News Column

Why forward guidance 2.0 is not only laughable but entirely unnecessary

February 13, 2014


AT A recent meeting of the Shadow Monetary Policy Committee, I was debating with Capital Economics's Roger Bootle whether interest rates should rise. His view was that they should not rise yet. I challenged him in the obvious way: "If not now, when?" To this he responded: "Later."

Roger's form of "forward guidance" is, in my opinion, a lot clearer than the Bank of England's ever was, and doubly so after its mangled attempt to re-frame the policy yesterday. The Monetary Policy Committee (MPC) policy is clearly nothing more than "we'll raise rates when we're good and ready", even though that is now obscured by being expressed via five guidance points and forecasts on a further 18 (!) indicators.

I'd said in advance that recent talk of changing the unemployment threshold was well wide of the mark, and that the Bank would instead talk about the output gap. But in truth, I'm not convinced it needed to adjust forward guidance at all.

Let's remember why forward Agree? Disagree? Got a sharp comment? guidance arose. Until April 2007, the Bank of England had (or at least everyone thought it had) a target of a 2 per cent annual rise in the consumer price index (CPI), from which it could deviate by no more than 1 per cent. Then the March 2007 CPI number came in at 3.1 per cent and, Lo!, it turned out that there was, in fact, no limit to how far above or below 2 per cent inflation was permitted to be. It was simply that being more than 1 per cent above or below meant the Bank governor writing a letter to the chancellor explaining why the governor was doing a good job, and getting a letter back telling him what a good job he was doing.

Thereafter, with nothing to limit how high it could go, inflation went to 5 per cent twice in three years (2008 and 2011). By 2013, inflation had averaged above 3 per cent for some time. Policymakers appeared concerned that markets would assume above-target inflation had only been tolerated because the economy was weak and that, as soon as growth returned, rates would rise to try to get inflation down. The first iteration of forward guidance was originally assumed to be reassurance to markets that the Bank didn't in fact care about inflation that much. It was framed in terms of interest rates certainly not rising until unemployment had come down to 7 per cent. In practice, that rather backfired, since this first form of forward guidance included a "knock-out" saying rates would go up if inflation were expected to be above 2.5 per cent. Since most folk had already concluded that the Bank wouldn't care about inflation at all in the recovery, having a 2.5 per cent "knockout" was regarded as hawkish, and markets responded in precisely the opposite way to what the Bank had hoped namely by increasing market interest rates and bringing forward the expected date of rate rises.

Having failed to convince anyone that rate rises would be later than they had thought, forward guidance then created a hostage to fortune. Unemployment dropped like a stone, and the 7 per cent threshold will shortly be breached with no high-inflation "knockout" obvious. That everyone expected forward guidance would be changed, rather than rates raised, demonstrates just how little credibility the Bank had.

So now the Bank is wriggling, talking about "slack" in the economy of 1-1.5 per cent. This is apparently quite different from an "output gap" of 1-1.5 per cent, because while such a small output gap would be eliminated this year by the Bank's stonking 3.4 per cent GDP growth forecast, "slack" will apparently remain even if growth is fast for the next two to three years.

This is both risible (literally) and unnecessary. The Bank now forecasts inflation will be close to 2 per cent for the entire forecast horizon, even at 0.5 per cent rates and more than 3 per cent annual growth. Believe that and you'll believe anything. But if you do believe it, then one could defend not raising rates on the simple traditional MPC basis of saying rates are at the right level to meet the inflation target. Forward guidance is thus pointless dross.

Governor Mark Carney tells us that the "new normal" for interest rates, even after recovery, will be 2-3 per cent. Since, at a first approximation, the equilibrium/neutral interest rate is given by the sum of the inflation target and the sustainable growth rate of GDP, at a 2 per cent inflation target that means Carney must expect that the UK's sustainable growth rate is and will remain well below 1 per cent - the most pessimistic view around. I can only hope he's wrong.

In the meantime, the best we can do on when rates will rise is Roger's judgement.

"Later" it is.

Andrew Lilico is chairman of Europe Economics and a member of the Shadow Monetary Policy Committee.

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Source: City A.M. (UK)

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