Friday, 13 September 2013

Forward Guidance

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There has been a very important development of the UK economic policy regime this summer that deserves scrutiny by anyone interested in the future path of the UK economy.
The new Governor of the Bank of England, Mark Carney, has persuaded the Monetary Policy Committee (MPC) to adopt a new approach to monetary policy.  Based on North American models, it introduces a more direct link between monetary policy and the real economy.  It aims to achieve three things: first, to calm fears that interest rates are likely to rise soon; second to support the short-term recovery; and, third, to provide a longer term framework that can influence market and inflation expectations.
In its latest Inflation Report, the Bank sees the prospects for UK growth as higher than before.  But, for inflation, its outlook is unchanged.  Importantly, the path of its growth forecasts (2-3% per annum over 2014-16) is not sufficient to remove the slack in the economy.  Because of this persistent degree of spare capacity (and negative/low real wage increases), underlying inflation is likely to remain subdued.  The MPC does acknowledge, however, that administrative and import price rises are still holding the rate of increase in the consumer price index (CPI) above target (2.8% in the year to July compared with a target of 2%).  Indeed, the target is not expected to be hit until well into 2015.
By May 2013, forward market interest rates had started to rise in response to better economic prospects.  The Bank, particularly Mr Carney, feared that expectations of interest rate increases were premature and that they might cut off a real economic recovery before it had really got going.  (Mr Carney worked in Japan when interest rates went up “too soon”.  Some believe this killed off an incipient recovery and kept the economy weak throughout the 1990s.)  Adding in his successful Canadian experience with forward guidance in the 2000s, the MPC (endorsed by the Treasury) has adopted “Forward Guidance” as its new policy framework.
Forward Guidance can be summarised as follows:
  1. The Bank expects to maintain its loose money policy as long as the economy has considerable spare capacity, provided this does not risk price or financial stability (see 3 below).
  2. Subject to ‘knockout’ conditions (3 below), the bank will not raise the 0.5% base interest rate and will maintain the asset purchase stock (quantitative easing) until, at least, the headline Labour Force Survey measure of the unemployment rate has fallen to/below a 7% ‘threshold’ (7.8% April-June 2013).
  3. The conditions for this approach, termed ‘knockouts’, are threefold.  It will, at least, consider an adjustment to policy if:
    1. The MPC forecasts the CPI measure of inflation 18-24 months ahead as likely to be 0.5 percentage points above the 2% target (i.e. greater than 2.5%).
    2. Medium term inflationary expectations amongst business, households and financial markets are no longer sufficiently “anchored” i.e. tending to increase.
    3. The Financial Policy Committee (FPC) judges that the monetary policy stance poses a significant threat to financial stability in a way that cannot be contained by other mitigating policies.
It is important to stress that the 2% inflation target still has primacy and any significant risks to this should mean the MPC amends or sets aside the new unemployment test.  Moreover, the ‘knockouts’ are not mandatory.  They are signals for the MPC to consider rather than triggers to necessarily raise interest rates or decrease asset purchases.
What does this mean in practical terms?
  1. Unless the economy accelerates much more than anyone now expects, base interest rates will stay low for the foreseeable future – perhaps, on current forecasts of growth and unemployment, staying at 0.5% until well into 2016/17.  This suggests firms and households can borrow now without worrying that loan costs will rise suddenly.  This should help to sustain the recent improvement in current demand.
  2. Inflation above target will continue to be tolerated as long as the forecast trend is for a move back towards that target within the normal time horizon (3 years).  This carries some inherent concern that there will be too much monetary stimulation over the medium term.
The Bank’s desire to prevent current growth petering out is laudable but there are risks with this approach.
  1. Markets will still speculate.  Every word that the Bank and the MPC use will now be poured over for signals of a change in forward guidance – even if only in nuance.  Market rates will still fluctuate in response to news, rumours and shocks.
  2. The unemployment rate is a lagging indicator.  The recovery will be well underway when it drops below 7%.  This risks that inflation pressures will be building up and interest rates will then have to go higher than might otherwise have been necessary to get inflation back under control.  This might dampen significantly the next economic cycle overall.
  3. Continued asset purchasing is building up a huge money stock that needs to be considered in terms of its inflation potential and what it might mean for the real economy when/if/how its withdrawal occurs.
  4. Savers and investors will suffer lower living standards and be less economically active, constraining real economic activity.  Real growth and low inflation are sustained by productivity gains incentivised by strong real returns over time.  Persistent low interest rates distort such signals.
  5. Moreover, persistent low interest rates mean that debt rebalancing will be less than desired.  Arguably, the housing market and other debt-driven activities need to be more realistic about what ‘normal’ interest rates imply for borrowing costs and loan sustainability over the economic cycle.  The risk is that renewed demand ‘bubbles’ blow up which are only heard when they pop.
All economic policy is about balance.  The MPC has now fixed monetary policy towards the easy end of the monetary ‘seesaw’ for some time to come.  To my mind, this attempt to bolster short-term demand may postpone fundamental rebalancing in the UK economy and risks worse supply adjustments to come.  Unemployment is like a broken leg.  It hurts and debilitates for some considerable time.  But, when it sets and repairs, a full recovery is possible.  Inflation is like a cancer.  It can grow inside the economy for some time before it is recognised.  Its treatment can be awful and ineffective (remember the 1970s/80s).  They are two very different manifestations of the economy.
The MPC’s job is to be pre-emptive: to stop inflation getting a grip on economic decision-making.  The danger of Forward Guidance is that it is reactive.  Waiting for unemployment to fall probably means higher inflation and higher interest rates in the long run than otherwise might have occurred.  Is this a price worth paying for more certainty about short-term growth?
The Bank has allowed inflation to stay above target for four years.  On balance, this was necessary to prevent something worse – depression and deflation.  I do wonder, however, now that confidence is rebuilding, whether the Bank has tied itself to a false premise.  My judgement is that the positive signal of a small increase in interest rates now (perhaps base rates up in four stages to 1.5% by mid-2014) would actually help the recovery, giving savers and investors hope of an earlier ‘return to normal’ and encouraging more current real activity.  This might actually bring unemployment rates below 7% sooner, boosting entrepreneurship towards productive supply without hurting debtors and dampening demand very much – indeed, a necessary part of a rebalanced recovery.
The bottom line for me is that the United Kingdom is not Japan, culturally or economically.  I fear that forward guidance, as currently set out, will be paid for by more of us for longer through higher inflation.  Indeed, it may delay the time that we can say the economy is ‘back to normal’.
Hopefully, I am wrong.  Governor Carney has left himself enough leeway to back away from or amend the unemployment trigger if necessary and he insists that the inflation target remains the MPC’s prime policy driver.  I suspect forward guidance will need to be adjusted from its summer 2013 position over the next few years.


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