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Forward guidance fails to deliver evolutionary leap
09 August 2013
Earlier this week, new Governor Mark Carney unveiled the Bank of England's (BoE) template for forward interest rate guidance. While other central banks have already ventured down this policy path, it does represent an innovation for the BoE and, to judge by its layered structure, perhaps indicates differing levels of enthusiasm amongst the Monetary Policy Committee (MPC) members. The ultimate aim of the policy is to inform market participants better about the Bank's reaction function and reduce the chance of markets prematurely pricing in rate hikes that could choke off the current recovery before it has been firmly established.
Let us first deal with the technical details of the newly announced policy framework. In many ways the Bank is simply following in the footsteps of the Fed. There is a conditional commitment not to raise interest rates at least until unemployment falls below a particular threshold, in this case 7%, while the BoE's guidance also has a tolerance threshold for future inflation of 2.5%. However, the Bank's version has additional embellishments with nuanced implications for policy. In particular, the Bank of England outlined three ‘knockouts’ that could induce a tightening of policy before the 7% unemployment threshold was breached, firstly forecasting inflation above 2.5% 18 to 24 months out; secondly signs that inflation expectations were becoming unanchored; and finally evidence that low rates were undermining financial stability. This flexibility is a nod to the more hawkish members of the MPC who are less convinced of the merits of forward guidance and more worried about future inflation risks.
So what does this all mean in practice? The first thing to note is that even with the recent signs of improvement in economic data, the Bank believes the UK economy has considerable spare capacity. This reflects the weakness of the domestic and global economy since the onset of the global financial crisis, as well as the still considerable public and private debt overhang. These headwinds, it argues, are likely to necessitate interest rates to stay low until mid-2016. For businesses and households this new policy gives a strong steer. At a time when global short rates are likely to rise due to Fed tapering plus US rate hikes, forward guidance from the Bank may help restrain the spill-over effects on short-term borrowing costs in the UK.
Despite this supportive tone, the fact that Carney's forward guidance comes with so many ‘get out’ clauses suggests that the Bank is reluctant to over-commit to these dovish inclinations. Our preferred way of thinking about what the MPC are doing is testing the speed limits to growth. The Bank's current forecasts rest on the assumption that the UK output gap is still very large and that a fair chunk of the trend decline in productivity growth since the recession is temporary rather than permanent. If the economy was to improve more robustly than currently assumed, with an earlier than expected fall in unemployment, higher wages and medium-term inflation pressures, then the prospect of a rate hike before mid-2016 would increase significantly. This is where the downside of forward guidance may lie – the central bank is trying to sell a present intention as a commitment, yet market participants know that they can easily renege at a future date.
So far the immediate financial market reaction has been one of moderate confusion – with a splintering of positive and negative opinions from investors and economists generally, based on their prior expectations. The ultimate judge, the bond market, reacted by bringing forward its expectations for when interest rates would rise, rather than pushing them further out, while sterling has appreciated. So something is amiss. At face value the market at present is not prepared to believe the 2016 projection for the unemployment threshold and thinks there are too many get-out clauses. This is in part because recent positive economic signals have been so overwhelming that they are taking priority over the Bank's stated intentions. This could well fade should the data stutter but for now this type of caveated forward guidance is not initially suppressing bond yields as Carney might have hoped for.
Scratching away further at the nuances of the Bank's guidance, there is both a formal statement to tolerate higher inflation (2.5% is now the effectively the new inflation target) and an intention to explore how quickly the economy can grow without pushing up against capacity constraints. Such intentions are not a positive for longer term bonds as, with the on-going recovery, the Bank will not offer any defence via further QE. This leaves the key battleground for forward guidance the 3-5 year sector of the yield curve and there are considerable doubts whether the Bank can truly influence anything other than the extremely short dates. On a positive note, the bond market is back to the fundamental game of data watching, something that has been sorely lacking throughout this extended period of QE, central bank watching and Euro crisis.
Looking forward, investors will be eager to see how Governor Carney seeks to bed in the new policy framework. Based on the initial market reaction it appears that establishing the credibility of forward guidance may prove rather hard work, despite the fact the policy approach has been used rather successfully in the US already. Of course, this was achieved with remarkably different underlying inflation dynamics than currently faced by the UK, where CPI is already above target. Throw in additional complications regarding unemployment as an accurate measure of labour market conditions, as well as the Bank's dismal forecasting record in recent years, and it seems clear that Carney is likely to have considerably less room for error than the Federal Reserve had to implement effective forward guidance.
Jeremy Lawson, Senior International Economist and Philip Laing, Investment Director, Fixed Income