How should we judge Mark Carney’s long-awaited “forward guidance”? Do the Bank of England’s pronouncements on the future path of interest rates amount to authoritative foresight or meaningless waffle?
I’d like to be positive. The new Governor has barely got his feet under the table and is a decent man. Amidst sky-high expectations, he faces a formidable task. Yet my instincts tell me that “forward guidance” is counter-productive and could even be highly dangerous.
Carney delivered his much-anticipated monetary sermon on 7th August. Already, the policy appears to be unraveling. Since the Governor spoke, 10-year UK gilt yields have spiraled, up over 20 basis points to 2.64pc, the highest level since October 2011. So borrowing has become dearer, not only for the government but across the economy. That, presumably, is not what Carney intended.
The centerpiece of this policy is the Governor’s reassurance that benchmark interest rates won’t increase from their record low of 0.5pc until UK unemployment drops to 7pc. Around 7.8pc of the workforce were jobless last month and the Bank projects a very slow recovery, with unemployment not falling below 7pc before late 2016.
Carney’s words were designed to stimulate the economy by reassuring firms and households that interest rates will remain relatively low for a long time to come. In the real world, the gap between the base rate and what commercial banks actually charge is extremely wide. In addition, and despite this disgracefully large “profit wedge”, many creditworthy borrowers – not least small- and medium-sized firms with good prospects – find that bank credit anyway remains unavailable.
Putting these major caveats aside, the prospect of ultra-low bank rates is obviously better for debtors – not least the millions of households on tracker mortgages – than a bank rate that’s likely soon to rise. That’s the rationale behind “forward guidance”.
In a bid to preserve what’s left of the Bank’s inflation-fighting credibility, Carney was carefully not to issue a “pledge” on interest rates. He revealed three “knockouts” – scenarios under which rates may change regardless of unemployment. The Bank could raise rates sooner if inflation is expected to exceed 2.5pc over an 18-24 month horizon, if inflation expectations are no longer “well anchored”, or if loose monetary policy “poses a threat to financial stability”.
Yet far from providing “more clarity over interest rates”, as Carney said it would, forward guidance seems to have sewn greater confusion. Since the Governor spoke, global investors have brought forward their collective estimate for a first rise in UK base rates to the autumn of 2015. That’s a year earlier than the Bank has signaled, suggesting that the markets don’t think the policy is credible.
A major problem faced by the Bank is that the economic data is improving – albeit from a very low base. UK GDP expanded 0.6pc in the second quarter and growth for 2013 as a whole could reach 1pc, up from 0.4pc last year. Manufacturing and construction are showing signs of life, with the much-quoted PMI index registering an optimistic 60.2 last month, up from 56.9 in June.
Retailers have also just reported their best July since 2006. So what if persistently high inflation and a deskilled workforce mean that real UK wages have fallen in each of the last six years since the credit-crunch began, confirming that this latest shopping uptick is just another piggy-bank-raiding, debt-fuelled binge. With politicians and commentators now openly talking of “recovery” and “escape velocity”, for that is what the electoral cycle dictates, there’s a growing sense that the Bank is being too pessimistic in order to keep its unemployment projection above the level that would spark a rate rise.
That’s the fundamental paradox at the heart of “forward guidance”. To make it work, the Bank of England, which is meant to be the most authoritative economic policy-making body in the land, needs to talk down the economy. That could not only disorient and unnerve the markets but also hinder the genuine recovery we all so desperately want to see.
“Forward guidance” is losing traction for reasons that go beyond recent improvements in the growth data. Investors are also concerned that the Bank will need to raise rates sooner than it says in order to counter inflation. The Consumer Price Index rose 2.8pc during the year to the end of July, we learnt last Tuesday. While that was marginally down from 2.9pc the month before, inflation still remains way above the Bank’s 2pc target, as it has been for no less than 45 months in a row.
While the government’s pet economic commentators are doing their best to ignore oil prices, it’s also the case that, despite a sluggish global economy, crude prices remain firmly above $110 per barrel. Egyptian unrest notwithstanding, oil markets remain tight, amidst ever-growing demand from the Eastern giants and, despite the fracking hype, an on-going struggle to source new supplies. That can only aggravate inflation.
In addition, while Carney can give “assurances” about what the Bank will and won’t do with regard to setting the base rate, he is just one member of the nine-strong Monetary Policy Committee. Well, Governors can be out-voted by the MPC, as Carney’s predecessor Mervyn King found on several occasions. That’s why gilt prices fell further, with yields rising, on the publication of the latest MPC minutes on Wednesday, showing that this latest policy wasn’t entirely unanimous.
Professor Martin Weale wanted one of the Bank’s “forward guidance” over-rules to be invoked if inflation was expected to breach 2.5pc on a shorter timeframe than the 18-24 months agreed by the rest of the committee. A former Director of the National Institute of Economic and Social Research, Weale is a widely-respected economist. His dissent served to underline the Bank’s inflation-related dilemmas, while bolstering lingering fears that price pressures could eventually run out of control.
As long as forward guidance fails to stick, investors will also assume that the Bank will resort to more “quantitative easing”, extending the already massive £375bn “asset-buying programme”. If gilt yields start to rise sharply, more QE is indeed likely – if only to keep government borrowing costs under control and avoid a disastrous debt spiral. But, as we’ve seen over the last 4 years, endless QE does little to promote growth and has big drawbacks, the worst of which may yet be still to come.
Perhaps the most immediate problem with more QE is that it would cause a sharp fall in sterling, which in turn would raise inflation via more expensive imports, so making forward guidance even less likely to work.
And let us not lose sight, also, of that fact that the Bank’s recent announcement amounts to a very profound shift in the UK’s monetary policy. Until now, the MPC has set monetary policy solely in a bid to anchor its inflation forecast close to the 2pc target.
This policy has served us well. The sub-prime crisis wasn’t caused by inflation-targeting, but by weak politicians, lax regulators and corrupt bankers. Amidst a lot of garbled technical pretense, we’re now explicitly trying to use monetary policy to lower unemployment at a time when inflation is already stubbornly above target and our vastly-indebted, double-deficit nation is in danger of provoking a run on our currency.
America, with its reserve currency, and massive economic strength, can get away with a dual growth-and-inflation target, but the UK can’t. My heart hopes that Carney’s “forward guidance” succeeds but my head tells me it won’t.