Bank of England and state-contingent forward guidance

by George Hatjoullis

Monthly annualised changes United Kingdom's Co...

Monthly annualised changes United Kingdom’s Consumer Price Index, from May 1997 to the present day (August 2011). They are not seasonally adjusted, and form the “headline” inflation rate that dominates the mainstream media. The time period correlates with the existence of the Monetary Policy Committee, responsible for keeping inflation within given limits. (Photo credit: Wikipedia)

The Bank of England made significant changes to its operation of monetary policy yesterday. It introduced state-contingent forward guidance. It also introduced a second consideration into the construction of monetary policy, diluting the single-minded pursuit of the inflation target. It introduced the unemployment rate. The BoE now has a framework more akin to the Federal Reserve‘s ‘dual mandate’.

This is not quite a return to the ‘full employment’ macro policies of the 1960s. The unemployment indicator is clearly a proxy for the degree of excess capacity, or deviation from ‘potential growth’, of the economy. Moreover, the inflation target remains the priority, albeit it seems a slightly higher target. One of the so-called knockouts from the guidance is if inflation is not expected to drop below 2.5% over the forecast horizon. What happened to 2%?

If inflation is on target to end below 2.5% then a 7% unemployment rate becomes the point at which the forward guidance is reviewed and the possibility of a rise in the ‘base rate’ becomes active. Otherwise the rate will remain at 0.5% for the duration of the horizon. Carney, the Governor of the BoE, made clear that the market is discounting a more rapid increase in rates than the MPC expects. One might have expected this observation to have hurt sterling. The opposite was the case with sterling strengthening across the board.

The implication is that the market was expecting something far more dovish. Looked at carefully the Carney forward guidance was quite hawkish. The discussion was about when rates will rise. There was no mention of more QE, although existing asset holdings will be maintained. Moreover, the economy is growing, albeit more slowly than the MPC would like to see at this stage of the recovery.

The real risk to the forward guidance is inflation. The 2% inflation ‘target’ has been more of a floor than a symmetric target, since 2005. For whatever reason the UK inflation rate has proved sticky in the face of recession and financial crisis. It has proved sticky even though wage growth has been exceptionally subdued. The inflation report can always be rigged to show inflation as coming down below 2.5% (again why 2.5%?) over the forecast horizon and thus ward off any unrequited increase in rates. However, after a while this will wear thin unless actual achieved inflation is also below 2.5%.

The problem is that no one knows the potential growth rate for the UK and the unemployment rate is most likely a poor proxy. The risk is that capacity is used up more quickly than expected and the state-contingent forward guidance is withdrawn sooner than Carney anticipated in his press conference. This is what the strength of sterling in the wake of the press conference implies. I am inclined to back the judgement of the currency market on this occasion.