Bank of England's strategy revealed
So at long last its official – the Bank of England’s ‘forward guidance’ policy is now in the public domain meaning that UK base rates are as good as fixed at 0.5% for the foreseeable future, assuming unemployment does not fall to 7%, which remains highly unlikely in the medium term. Although the ‘gap’ between the current unemployment rate of 7.8% and the likely automatic intervention rate of 7% seems relatively small beer, the last four years have seen unemployment remain stuck between 7.8% and 8.4%, and the last time unemployment was below 7% was back in the first quarter of 2009. At that time CPI inflation was just within its target range at 2.9%, with interest rates hitting 0.5% for the first time as the recession reached its peak. What we can clearly assume is that even if current growth remains positive, unemployment is unlikely to start to drop appreciably for at least 18 months, let alone hit the 7% target. Indeed, there is as much likelihood that unemployment will rise again, rather than fall, meaning that any interest rate rise is, indeed, likely to be a long way away.
This announcement is the first clear sign that the new Governor, Mark Carney, intends to make monetary policy more open and transparent – surely a positive move in anyone’s books. So it is now out in the open that the unemployment numbers provide significant and tangible evidence of whether macro-economic policy is working in general, and whether, specifically, monetary conditions will be tightened or loosened during Mr Carney’s tenure at the Bank. Of course, while the Bank of England’s brief has not changed – namely to achieve the inflation target of 2% while creating a stable financial environment – the acceptance that conventional monetary instruments have failed to bring about sustained recovery along with the appointment of a Governor Carney, brings firmly to an end the Mervyn King era.
As expected, business reaction has clearly been very positive, and with interest rates now fully predictable in the short run, business planning and investment decision are made that much easier to evaluate, and investment that much more likely to happen. This is, of course, exactly what the macro-economy needs if it is to crawl into the ‘recovery position’.John Cridland, CBI Director-General, confirmed the general view from UK business when he said that “greater interest rate certainty and clarity from the Bank should provide a shot in the arm for business and household confidence. He went on to state that “businesses will be buoyed by the support it should give to the economic recovery and be reassured by the built-in conditions around inflation and financial stability.” The response from the TUC was equally positive, with General Secretary Frances O'Grady saying that 'the TUC has long campaigned for the Bank to take account of unemployment when setting economic policy. Today's announcement shows that the Bank understands a real recovery is something that benefits ordinary people, and not just an upward blip in economists' outlooks.
Of course, one wonders whether anything really has changed, other than the fact that we all know rather more about how the Bank will operate in the future. But perhaps that is not the point as one could equally argue that the big change is indeed precisely that – that this forward guidance and greater transparency and makes expectations rather more rational over a longer period than they would otherwise be. In other words, when the recovery comes firms and households will have a longer period of certainty about low interest rates than in previous recoveries. This in turn will encourage business to get on with doing what it does best – namely, adding value, generating jobs, and creating wealth, all of which will help create sustainable growth. As the Bank of England put it itself (Inflation Report, August 1st 2013) its forward guidance “should reduce the risk that, as the recovery gains traction, market interest rates rise prematurely and people worry excessively about early rises in borrowing costs. By so doing, it should help to secure a recovery of sufficient strength and duration to return output, employment and incomes to their full potential levels, consistent with medium-term price stability.”
The Bank of England have been at pains to state that the 7% unemployment figure is simply a ‘threshhold’ and not a ‘trigger’ for a policy change. The acid test will come at some point in the future when unemployment does near 7%. If interest rates do not edge upwards, then credibility will take a huge dent. But this, clearly, is some time off yet.