The Bank of England and Forward Guidance revisited
by George Hatjoullis
The revised forward guidance has removed the reference to unemployment as a catalyst for rate increases. The CPI remains a target because it is how the BoE mandate is framed. The general tone of the guidance is that rates will stay low for some time and even when they do rise, they will do so only slowly and not to the levels seen in the past. Dovish guidance you might conclude. Not so the market it seems, with sterling strengthening in response. The market is still inclined towards the BoE raising rates sooner than the guidance implies. This was also the case when the guidance was initiated and this seemed to be the correct response. However, there is one important difference on this occasion:
“CPI inflation has returned to the 2% target sooner than expected. Upward pressure from import and administered and regulated prices remains, but slack is providing a countervailing force.” BoE Inflation Report, February 2014, p.38.
Inflation has returned to target sooner than expected. Moreover, it has done so despite sticky administered prices. It has done so despite historically low interest rates and ample central bank liquidity. It has done so despite somewhat stronger than (most) expected growth in 2013. It has done so despite a very strong UK housing market. What if the CPI continues to decelerate and settle below the target rate much like has been the case in the US and eurozone?
In previous blogs discussing the risk of deflation in the eurozone, I have cited the somewhat counterintuitive drop in the UK CPI as indirect evidence of a global disinflation environment. It is interesting to note that the BoE is also surprised by the UK CPI drop. The UK CPI is notoriously sticky on the downside and the last time it briefly dipped below 2% was in the aftermath of the 2008 financial collapse (see above chart from BoE report). It then promptly shot back up to 5%! This time this may not happen. In fact given all that has gone before, the risk is it continues on down.
The BoE monetary policy mandate is framed in terms of the CPI. If the CPI is lingering significantly below 2% then rate rises may prove difficult to justify. The BoE can claim that monetary policy works with a lag and that it is preempting future inflation increases but this would be a transparent fib. If monetary policy works with a lag why has the inflation target been hit after a sustained period of easing? Clearly, something else is going on and until the BoE understand what it is it is unlikely to risk raising the bank rate.