Aug
12
2013

12th August 2013: Forward Guidance

The Bank of England’s forward guidance on montary policy allays investor confidence while pledging to give priority to price stability.

The Bank of England, under Mark Carney’s stewardship, has finally issued its much-anticipated ‘forward guidance’ on monetary policy and explicitly linked interest rate movements to the Labour Force Survey headline measure of the unemployment rate. The Monetary Policy Committee (MPC) intends to keep Bank Rate at its current low of 0.5% until the unemployment rate falls to a threshold of 7%. Currently, the unemployment rate stands at 7.8%.

But there are some caveats to this stance: first and foremost, should inflation be expected to stay above its target of 2% by 0.5pp for a period of 18-24 months, or medium-term inflation expectations drift higher, or financial stability comes under threat, the MPC could alter the rate regardless of the unemployment rate.

While the Committee has moved to reassure borrowers of a low-interest rate environment in the recovery phase, it is at the same time seeking to bring inflation expectations under control now that there are some early signs of activity picking up. And by explicitly specifying caveats and ‘breakout’ points, it has still retained a degree of flexibility and autonomy over interest rate decisions at turning points in the economy.

The Bank of England governor is keen to stress that the unemployment rate reaching 7% will not be an automatic trigger for interest rate rises and neither is this the aspirational ‘long-term unemployment rate’ for the UK economy (which is closer to the 5% mark). Rather, it is simply a benchmark that would suggest that the economy is on a strong enough footing that interest rate rises would not be out of the question, should the need for this stance arise.

Thus, the MPC will ‘maintain the current highly stimulative stance of monetary policy until economic slack has been substantially reduced, provided this does not entail material risks to either price stability or financial stability’. Governor Carney’s view that the Bank is unlikely to be in a position to move on interest rates for the next three years implies an expectation that the unemployment rate will not be below 7% before then. This is not far off Experian Economics’ forecasts for the economy which show unemployment hitting around 7% in early-2016 and interest rates rising around the same time.

Markets have reacted largely positively to the announcements with sterling buoyed by this news despite the pledge to keep interest rates at historic lows. It seems that the decision to focus on the twin objectives of maintaining price stability and reducing uncertainty about the future path of monetary policy as the economy recovers was well-taken by the new Bank of England leadership.

For more weekly economic updates visit #EconomicsWTOF or Weekly Topic of Focus page.

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