A few years ago I developed a theme, which I used more than once in books, and often in talks, called the seven ages of monetary policy. The story started in 1976, with the International Monetary Fund imposing monetarism on a reluctant Labour government and reached its seventh phase in the Eddie George/Mervyn King era of an independent Bank of England targeting inflation.
Seven different versions of monetary policy over 30 years or so suggests a very changeable picture, though each lasted for an average of four years or so.
So what are we to make of Mark Carney’s forward guidance, launched in August and abandoned a few days ago? Six months is barely a brief encounter, let alone an age. It may not even merit a footnote in future accounts of monetary policy.
I’ll come on in a moment to what I think is the significance of the successor to forward guidance, the best description of which is fuzzy guidance. But how did the Bank governor get himself into such a tangle?
This is not to condemn his intentions. When Carney arrived at the Bank last summer, the first stirrings of stronger growth were emerging but there had been false dawns before. He wanted a mechanism to be able to reassure firms and households that the monetary policy committee (MPC) would not be trigger-happy on interest rates and that it would give the recovery time to breathe.
There is some evidence, presented by the Bank in its inflation report, that the governor and MPC members saying this gave businesses more confidence to invest, though it appears to have gone over the heads of individuals.
But it is stretching things to breaking point to regard forward guidance 1, as we must now call it, as a success. A policy that was supposed to kick the question of rate rises into the very long grass quickly became one in which every bit of good news on unemployment was accompanied by a wave of speculation about the timing of interest rate hikes.
It is impossible to do a controlled experiment with these things but there has probably been more such speculation in recent weeks than there would have been in the absence of guidance. In the past, a few well-timed nods and winks would have been enough to dampen rate speculation – the legendary governor’s eyebrows – now the Bank is forced to use its full armoury to get across what should be a simple message.
How did it go wrong? Carney, an urbane and well-informed Canadian central banker, lacked expertise and experience on the British economy. His choice of a 7% unemployment rate as the threshold before which a rate hike would be considered reflected that, though Bank staff and other MPC members should have alerted him.
He rightly pointed out that the rapidity of the fall in unemployment took everybody by surprise. But it took the Bank, which did not expect it to happen until 2016, more by surprise than most.
Carney says he regrets nothing about the first phase of forward guidance, though he gave a broad hint that he wished he had chosen a lower unemployment rate, say 6.5%, for the threshold.
Had he done in August what he did last week, however, by linking future rate decisions to a range of measures of spare capacity, but accompanying it with the message that those measures pointed to a prolonged period of unchanged interest rates, he would have done himself a big favour.
So where are we now? Forward guidance 2 has had plenty of people scratching their heads. A rate rise will not be considered, it says, until more of the margin of spare capacity in the economy has been used up.
That spare capacity is, however, estimated at just 1% to 1.5% of gross domestic product. Taken in conjunction with the Bank’s punchy new growth forecasts, 3.4% for this year (up from 2.9%), and 2.7% for next year (up from 2.5%), it implies that rates could be rising very soon.
But not too soon. If forward guidance 1 was simple but flawed, its successor is complex. The Bank has released an array of assumptions and forecasts used to underpin its expectations about spare capacity.
Spare capacity, to complicate things further, is not the same as the “output gap”, which is conventionally used (including by the Office for Budget Responsibility) to measure the amount of headroom in the economy.
The Bank’s measure of spare capacity is a movable feast. At present the Bank thinks what it calls the medium-term equilibrium unemployment rate is between 6% and 6.5%. But it also thinks that, as the recovery progresses that equilibrium rate will come down. Business investment, which it predicts will rise 11.5% this year, 12.75% in 2015 and 13.75% in 2016, will add to the amount of capacity in the economy.
The result of this is that, on the Bank’s projections, which run through to the early part of 2017, spare capacity in the economy is not used up. Those forecasts come with a huge health warning, given the experience of recent months. But do they imply that we will see no rise in Bank rate from its historic low of 0.5% for another three years?
No. For me the most interesting aspect of the new guidance, and the inflation report, is that it has begun to look forward to the day when interest rates will rise. Yes, Carney was keen to stress that when rates do rise, they will only move to levels well below the pre-crisis norm of about 5%. And yes, he may be one of the last MPC members to actually vote for a hike.
But, in response to a question I asked, Charlie Bean, the deputy governor, said the MPC would begin to raise rates before spare capacity in the economy was used up, because to leave it until it was would be too late.
Carney, for his part, did not demur over the market path for interest rates, which implies the first hike in the second quarter of next year and a gradual rise to 2%-3%, where it sticks, over the next three years.
That looks like a sensible path. An emergency level of interest rates cannot last forever. Personally, I would like to see the first hike next year coming before the May general election. The Bank, after a bit of a battering, needs to reassert its independence. That would be a pretty good way of doing it.
This piece is cross-posted from EconomicsUK.com with permission.