It came as no surprise that the Bank of England left its monetary policy stance unchanged at its latest Monetary Policy Committee meeting last week. The nine MPC members voted to hold the policy interest rate at its record-low level of 0.5% for the 59th consecutive month, while also maintaining the Bank's stock of asset purchases (via quantitative easing) at £375bn.
Nothing to see here? Well, not necessarily. Tomorrow the Bank of England will publish its quarterly Inflation Report, and alongside its revised forecasts for growth and inflation there is likely to be considerable market interest in what the central bank has to say about its much-maligned policy of "forward guidance".
Introduced by the new Bank governor, Mark Carney, just seven months ago, forward guidance followed the lead of the US Federal Reserve by linking future changes in UK monetary policy to conditions in the domestic labour market. Mr Carney stated last August that the Bank would not consider tightening its current policy stance until the unemployment rate fell below 7% (subject to caveats relating to financial stability). At the time the Bank believed that this threshold wouldn't be met until the second half of 2016. The aim of forward guidance was therefore to reassure the private sector that short-term interest rates would remain at 0.5% for at least another three years, reducing uncertainty and encouraging households and businesses to borrow and spend.
That was the plan. However, since mid-2013 the rapid improvement in a range of UK economic indicators—including a sharp fall in unemployment from 7.8% to 7.1%—has prompted increasing debate, and no little confusion, over the Bank's monetary stance, rather than the greater clarity that Mr Carney had intended. Bond investors have been pricing in policy rate hikes occurring much sooner than the BoE's current forecasts suggest, prompting considerable media interest in when UK interest rates may start to rise.
When forward guidance was launched, the Bank of England's own analysis implied that it viewed the unemployment rate to be the best available indicator of spare capacity, and thus inflationary pressures, in the UK economy. However, as the jobless rate has declined at the same time as headline inflation has eased back to target, Mr Carney and his colleagues have been forced to backtrack from their original guidance message. Indeed, last month in Davos the governor implicitly acknowledged that the unemployment threshold had to all intents and purposes been dropped.
"Members saw no immediate need to raise Bank Rate even if the 7% unemployment threshold were to be reached in the near future" – MPC minutes, January 2014
Although the economy has rebounded unexpectedly strongly over the past year—annual real GDP growth of 1.9% in 2013 was the fastest since 2007—the overall period since the global crisis has seen the UK recovery lag well behind that of most other G7 economies. This latter point is one that the Bank governor, Mark Carney, and some of his MPC colleagues have been keen to stress in an effort to refocus attention away from the simple 7% threshold. Noting that the pick-up in economic activity has come from a very low base and that the level of UK GDP still remains some way below its pre-crisis level, the governor has also highlighted the still subdued trends in real wage growth, on-target inflation and falling long-term unemployment as evidence that there is still considerable slack in the economy. This supports Mr Carney's recent statement that "the recovery has some way to run before it would be appropriate to consider moving away from the emergency setting of monetary policy".
The debate over spare capacity is not clear-cut, however. A number of economic commentators have noted that a range of labour market indicators—not just the jobless rate—have tightened over the past six months, that productivity trends remain very weak, and that recent survey data point to constraints on capacity and recruitment returning close to pre-crisis levels in some areas of the economy.
Easy does it
Mr Carney has so far appeared to adopt a more dovish stance than some other members of the MPC, although it is clear that a majority of the Committee still see little prospect of a rise in the policy interest rate anytime soon (in line with most independent forecasters, we don't anticipate any policy tightening until at least early 2015). But with the positive near-term economic outlook expected to support a further reduction in the jobless rate to below the 7% threshold in the coming months, the Bank of England now has little option but to revise its forward guidance policy.
What form this could take is open to debate—options include:
- lowering the unemployment rate threshold
- announcing another form of "state-contingent" guidance linked to different indicators
- revealing individual MPC members' views on future rates; or
- specifying an explicit period during which interest rates will remain on hold.
Whatever is decided, Mr Carney for one will hope that it proves to be a more effective and more enduring policy than the Bank's initial effort.