Wednesday, 7 August 2013

The forward guidance Hokey-Cokey

The Bank of England’s monetary policy committee, led by the redoubtable Canadian Mark Carney, is adopting ‘forward guidance’ with a commitment to keep policy rates at 0.5%) as long as the unemployment rate is above 7%, unless doing so makes them fear missing their inflation target, or causes inflation expectations to rise too much or causes financial instability.

The market reaction was firstly to sell the pound and lower interest rate expectations ahead of the release of the Inflation Report and the forward guidance announcement.  Then, the pound was sold and rate expectations lowered with even more vigour as the news was released, only for the market to think again, turn around and buy the pound, selling short-dated gilts as the day wore on.  Sterling has ended the day about a percentage point higher against both euro and dollar, short sterling futures have sold off (modestly, having reversed the earlier gains) and gilt yields aren’t very different from where they were yesterday. The FTSE 100 is about 1% lower, performing better than the Nikkei but falling more than the S&P.

This seems a bit like the Threadneedle Street Hokey Cokey!

The purpose of forward guidance is to ensure that those involved in the wider economy, rather than those active in financial markets, understand that interest rates will stay low for ‘a long time’. That allows people to be confident that the period of super-low rates won’t be reversed suddenly. As for the conditions attached to the forward guidance, they are there to make sure that no-one fears that the central bank is being irresponsible. Of course, that’s completely impossible – some people think current rate levels are daft, as it is. The choice of conditions which would requires the MPC to change course is chosen to be both ‘credible (ie, to show the Bank is doing its job properly) and unlikely to be met (ie, they don’t actually want to be raising rates before the unemployment gets below 7%).

So, how did Mr Carney do? Any inflation hawk will simply turn around and point out that making unemployment a specific target of monetary policy, as well as inflation, is dangerous. In practise, even the Bundesbank used to care about unemployment, but making lower unemployment an objective does mean the central bank mandate has changed from fighting inflation to helping the economy.

My main concern – and to be fair this was the case long before the announcement was made - is that targeting lower unemployment subject to where inflation (specifically CPI inflation) implicitly assumes that there is still a clear trade-off between the two, and the monetary policy should focus on the trade-off.  And if that assumption is wrong, there is a very real risk that any specific unemployment/CPI target that the Bank came up with, was in danger of being either too easy to hit or too likely to miss.

What happens if GDP growth continues to be sluggish (likely) but is accompanied by a further fall in unemployment (possible), while consumer prices rise but wage growth remains very weak (also likely)? At the moment the economy is growing at an annual rate of 1.4% (in terms of GDP), and the Bank of England forecasts (optimistically) a steady acceleration from here. Even this pace of GDP growth is seeing employment increase, albeit with much criticism of the kind of jobs that are created (see the whole debate around zero hours contracts). Economic growth may not slow and employment may continue to grow too, but  if we are creating 'the wrong sort of job',  why would we see a pick-up in wage growth. Maybe, as the economy shifts from a financial service focus to a manufacturing one, we will see wage growth pick up as skills shortages in manufacturing grow. Maybe we will see downward pressure on financial services compensation ease and maybe, even, growth will deliver better tax revenues and as the fiscal position improves we will see public sector wage growth pick up. But mostly, there is plenty of excess labour globally and that is what is making wage-bargaining so one-sided even in economies with some kind of economic recovery. But even if wage growth remains low, that won’t keep CPI inflation down. This week saw the news that rail fares may rise by 5% or more on some commuter lines in the terms of the deal with rail operators. Gas, electricity, transport and education prices are all insensitive to what happens to wages or indeed to the economy. CPI inflation in the UK is supply, not demand-driven and worse still, it isn’t supply of labour which drives it.

So my first concern is that at a time when rates should say low and help the economy rehabilitate, the focus on unemployment and CPI inflation threatens to get in the way. Mr Carney would not want to tighten in the face of modest growth, but not doing so would undermine BOE credibility, perhaps severely. And my second concern is that by telling markets rates are staying lower for longer but giving them unemployment and CPI inflation as guides to when things may change, we will see markets price in very low rates for 2 or 3 years, and then assume a steep rise in rates thereafter. And since markets are by their nature forward-looking, pricing in the steep rate rise in the 3-5-year horizon risks undermining any good work from the forward-guidance in terms of anchoring rate expectations in the first place. If I am to price in higher rates 5 years ahead, I will sell gilts and buy the pound now. Which I exactly what happened after the initial positive reaction to the policy announcement.

I expect we will now see a whispering campaign to clarify what forward guidance really means, and to make sue that we all understand firstly  that the MCP remains firmly focusd on fighting inflation, and secondly how clear they are that rates are likely to be down at these lvels for years to come. but I don't know if inflation expectations can be re-anchored, or if the nagging fear that when rates start to rise, they will go up quite a lot further and faster than those elsewhere, can be soothed with a few words.

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