The watered down version of Forward Guidance

August 8, 2013

The new governor of the Bank of England has shaken things up at the Old Lady. Not only has he brought a touch of glamour to the Bank, he is considered a George Clooney look-alike by some, but he has dramatically altered the way that the Bank does things. Since he arrived a little over a month ago we’ve had statements released after meetings and now the Bank has adopted forward guidance.

But has this central banker with a twinkle in his eye run into a brick wall at the BOE? The forward guidance that he announced during the August Inflation Report went down like a lead balloon. The markets immediately challenged the Bank’s pledge to keep interest rates low until 2016, UK Gilt yields at one point rose to their highest level since before he joined as Governor, and the pound also jumped sharply.

Essentially, the BOE’s ambition with forward guidance was to keep interest rates low so that consumers and small businesses feel confident enough to buy that car or employ more staff.  After successfully navigating the Canadian economy through the financial crisis, hopes were high for Carney, so why aren’t markets reacting as he would like?

It’s mostly because they don’t believe him or the rest of the Bank. At the same time as they pledged to keep interest rates low for 3 years, they also revised up their growth expectations. Stronger growth surely means higher interest rates, right?

The press conference was all a bit painful. Carney sounded more like a lawyer than a banker, and although he introduced forward guidance it came with a list of caveats the length of my arm. Just because the BOE now has an unemployment rate threshold that doesn’t necessarily mean that when the unemployment rate hits 7% rates will rise immediately. There were three “knockout” situations that could render the unemployment rate threshold null and void:

  • Rates could rise before the unemployment rate falls if the policy threatens to boost inflation more than 0.5% above the 2% target.
  • Rates could rise if this policy threatened to cause another credit bubble and hurt financial stability.
  • Rates could stay low after the unemployment rate falls through the threshold, if other economic signals are showing signs of weakness.

The BOE press conference was a bit like an episode of “Yes Minister”, where the new minister comes into the office brimming with new ideas, only to be told that the office doesn’t work that way and the old ways of doing things persist. Although the BOE has become a bit more flexible under Carney’s stewardship, the list of escape clauses that accompanied forward guidance ensured that the Bank was not backed into a corner and Carney did not fully get his dovish way.

Of course you could argue that Carney has arrived at the BOE just as the UK economy is turning a corner, indeed the BOE revised up its growth forecasts for this year and next. However, on the other hand you could argue that forward guidance and a sincere pledge to keep rates on hold for a prolonged period is exactly the confidence boost that the markets need to help the UK on its way to escape velocity.

But, if Carney’s first attempt at forward guidance fails to deliver the goods then, if he is clever, he could make this work in his favour as it may force the rest of the MPC to deliver a more forceful type of guidance in the future.

Although Carney may not have cemented the Bank’s pledge to keep interest rates low for the next 3 years firmly into the markets’ consciousness, one thing is for sure, he has definitely secured his place as the latest thinking woman’s crumpet.

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