Forward guidance is dead. Long live forward guidance. That was
Despite the pick-up in growth over the past year, the MPC thinks there is enough slack left as a result of the deepest recession in living memory to warrant holding borrowing costs.
Even when they do start to go up, and the City thinks that is unlikely until 2015, rates will edge up in quarter-point moves. The peak will be 2%-3% rather than the 5% norm before the financial crisis. The plan is to give firms and individuals the security to take out loans knowing they will not be hit by a sudden upward lurch in interest rates.
What was far less clear from the Bank's inflation report and Carney's press conference, was why the new form of forward guidance will be more reliable than the old form.
Forward guidance Mk I targeted unemployment. When the jobless rate fell to 7%, the MPC pledged to have a think about whether rates should be increased. The Bank considered unemployment the best proxy for spare capacity in the economy. It rejected other indicators.
The Bank said unemployment would take two-and-a-half years to get to 7%. It has taken less than six months, which has forced a crash rethink.
Forward guidance Mk II involves the Bank's assessment of the output gap, which has none of the advantages unemployment has as a yardstick. Very few people know what an output gap is, and even those who do have widely different views about how big it is.
The output gap is the difference between the actual level of activity and its potential level. Policymakers assume that the economy has a long-term trend rate of growth, which in the
In recessions activity falls below this level and so there is scope for the economy to grow faster than trend during recovery periods without inflation picking up. But it is also assumed that some of the damage caused by recessions is permanent, because investment is scrapped and unemployed workers lose their skills.
As a result calculation is highly subjective. The Treasury publishes a range of estimates from forecasters varying from 0.8% to 6%. So forward guidance is now extremely fuzzy.
The Bank does not really know how big the output gap is, nor how quickly it will close.
And that makes its pledges on borrowing costs rather less cast-iron than Carney would have us believe.
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