The Bank of England has updated its forward guidance policy (12 February 2014) in the light of the December unemployment figures, which showed a sharp drop to 7.1% - just short of 7% unemployment threshold set n August. Despite the unexpected fall in the unemployment figures, the Bank estimates that there is still sufficient slack in the economy to keep interest rates at 0.5%.
According to the Bank, slack exists within the labour market given that actual unemployment (at 7.1%) is still greater than what it believes to be the ‘medium-term equilibrium rate of unemployment’ (at 6% to 6.5%). The Bank also indicates that slack also exists given that workers would prefer to work more hours as the economy grows, which, if true, will clearly dampen possible upward wage pressure. This week’s statement also signals that the Bank will consider a wide range of indicators, though still defending the unemployment threshold, give that unemployment is one of the least volatile indicators of economic activity, and because it is ‘widely understood’ as an indicator of economic well-being. Even when slack disappears and the economy returns to somewhere near its trend rate, interest rates are likely to remain at levels well below those prior to the financial crisis, given the Bank’s estimates of the existing output gap (at 1.5%).
Making various assumptions, the Bank expects that rates will rise to between 1% and 2% during 2015 and 2016. It is certainly not clear yet that the recovery will be sustained, and in a recent BBC interview, Governor Carney warned that the recovery was ‘not yet secure’ nor was it ‘balanced’. Only when business investment and exports pick up substantially, and growth is less reliant on rising household spending and a savings run-down, will the recovery be regarded as balanced.