Let me take Margaret Thatcher’s famous words on becoming prime minister in 1979, when she quoted St Francis of Assisi, and adapt them to deal with interest rates and the Bank of England.
Where there was certainty now there is confusion. Where there was harmony, now there is discord. Will forward guidance, Mark Carney’s big idea, turn out to be one of the shortest-lived monetary policy experiments in history?
I shall come on to that. The big question, of course, is when interest rates will start to rise. In August, shortly after the new governor arrived fresh from the Canadian prairies, the answer as he launched forward guidance appeared clear enough.
The monetary policy committee (MPC) would not even contemplate a hike in Bank rate from its current record low of 0.5% until the unemployment rate got down to 7%, and it did not expect that to happen until the latter part of 2016 at the earliest.
Though dependent on the state of the economy, the clear message was that people and businesses could relax about a rise in interest rates for three years (savers, of course, are desperate for a rate rise but that is another story).
Now fast forward to last Wednesday and the publication, three months on, of the Bank’s latest inflation report. To say that the Bank has shifted its view on the economy is an understatement. To stay with the religious theme, there have been few bigger changes of mind since Paul was on the road to Damascus.
On the same basis that the Bank thought in August that unemployment would not get down to 7% until mid to late 2016 – the assumption Bank rate stays at 0.5% – it now thinks there is a 50-50 chance of getting there roughly two years earlier, in the fourth quarter of 2014, just a year from now.
Even assuming rates rise a little in line with market expectations (which seems a bit of a contradiction) the unemployment rate gets down to 7% in mid-2015.
In the space of three months, forward guidance has apparently moved from the MPC not contemplating a rate move for three years to it being firmly on its agenda in 12-18 months time. For a policy that was supposed to enable firms and individuals to plan for the medium-term, this looks worryingly skittish.
Let me try to interpret and adjudicate, starting with the Bank’s new forecast. Now I am as optimistic as anybody but I fear that the Bank may have had a little too much sun on that road to Damascus. It may have jumped too far into the optimistic camp.
Its growth forecast for next year on the assumption of no change in interest rates is 3.4%. To set that in context, the average new independent forecast for growth next year is 2.2% and the most optimistic is 3%. The Bank has gone out on a limb.
The Bank’s growth forecast on the market interest rate assumption (in other words that rates gradually creep up to 1.7% by 2016) is just under 3%. Still very strong.
I hope it is right but, while most of the recent economic news has been gratifyingly upbeat, we should not assume it is plain sailing. Retail sales, for example, fell by 0.7% last month and were merely flat over the past three months. Eurozone gross domestic product rose by just 0.1% in the third quarter and in some leading economies, including France and Italy, it fell.
It is this very strong forecast that drives the Bank’s prediction of a much earlier fall in unemployment that it previously predicted. Here again, it is worth questioning the numbers.
The latest unemployment reading is 2.47m, 7.6% of the workforce. If you thought unemployment had been close to 2.5m for some time, you would be right. Despite strong growth in employment, 377,000 over the past year, the level of unemployment has barely moved from that 2.5m level. The unemployment rate has fallen over that period because the size of the workforce has grown, but only from 7.8% to 7.6%.
Now, if the Bank is right about 3.4% growth next year, it is possible that employment will rise even faster than its very big rise over the past year. Three large falls in the monthly claimant count, a different measure of unemployment, have increased optimism among forecasters about the pace of the fall in unemployment.
But it still seems to me to be what sports commentators call a big ask for the unemployment rate to get down to 7% in a year, or even 18 months. It could, if productivity growth continues very weak, which would endorse fears that there is not as much spare capacity in the economy as thought.
Equally, however, if we believe a record 1.46m people are working part-time but really want a full-time job and if some of the growth in employment continues to come from people beyond normal retirement age, the unemployment rate could be slow to fall.
It is complicated, and it is one reason why I said when forward guidance was launched in August that it was not the best-designed policy in the world, looking very much as if designed by committee, which of course it was. The Bank is now finding that out.
The debate will continue on when unemployment gets down to 7%. Whenever it happens it has to be said the Bank’s new forecast is a victory for the many economists who criticised it for stretching 7% too far into the future.
For everybody else, what matters is when interest rates rise. Carney’s mantra on this is a familiar one: that 7% unemployment is a threshold not a trigger. When it is reached the MPC will start thinking about whether to hike rates but is under no obligation to do so.
Though the Bank’s new forecast made the governor’s task uncomfortable last week, he was helped by a sharp drop in inflation, from 2.7% in September to 2.2% in October. If inflation is close to target, and predicted to remain so, there may be no reason to raise rates even if unemployment has fallen to the threshold level.
A better way of looking at it is to stand back from the unemployment numbers. This, by the way, is how I beliecve Carney looks at it.
The economy is still roughly 2.5% smaller than it was before the crisis. The gap relative to what it might have been if the economy had avoided crisis and recession (a big if) is even larger, perhaps 15%. Some of that gap will be permanent but the hope has to be that not all of it is.
So what is the Bank trying to do with forward guidance? To give the recovery time to breathe, not just until the level of gross domestic product gets well above those pre-crisis levels, but also to permit what could be a long period of above-trend growth to claw back as much of that lost output as possible. That process is still in its infancy, despite recent stronger growth. As a result, I would not be looking for any movement on interest rates for the next two years, and possibly quite a bit longer.
So is forward guidance still alive? The past few days have not helped it, though the policy was only ever going to tested when growth picked up. Carney says that households and businesses should have confidence that rates will stay low and “not just that the glass is half full, but that it will be filled”. He is still guiding us not to expect rates to go up.
This piece is cross-posted from EconomicsUK.com with permission.