Caption (above) first appeared in a cartoon published in 1797 by James Gillray titled ‘The Old Lady of Threadneedle Street in danger’. It depicts William Pitt the Younger (Prime Minister) pretending to woo the Bank which is personified by an elderly lady. Hence, the bank is often referred to as ‘The Old Lady of Threadneedle Street’.
Yesterday the Bank of England announced a change in strategy, the first move under the new Governor Mark Carney. Alongside the quarterly inflation report, the Bank of England announced that it would be issuing explicit guidance about the future path of monetary policy, namely, that policy would remain loose until the economy returned to strength. Coined ‘forward guidance’, the Bank has announced that it will not consider raising the base rate of 0.5% until the Labour Force Survey measure of unemployment has fallen to 7%.
Against a back drop of high inflation and weak GDP growth the Bank faces a trade-off between growth and price stability. The purpose of forward guidance is to reduce uncertainty, and communicate the future path of monetary policy. Policy works more effectively when central banks and markets have perfect information about future money supplies and interest rates. However, the MPC takes into account many factors and it is impossible to communicate all of them. Under forward guidance then, the Bank anchors expectations to one medium term target, i.e. unemployment which should act as a coherent framework in which the bank can interpret and manage these expectations.
Monetary Policy Since 2008
Following Bank independence in 1997, a long-term inflation target at 2% has been the preferred method of guiding expectations on the path of policy. And usually, when a recession or slowdown occurs, a fall in demand causes price deflation and central banks accommodate by increasing the amount of money it supplies to the economy, which reduces interest rates and stimulates through a number of channels, including by raising prices.
As expected, shocks and disturbances will push inflation away from target from time to time, some of these shocks if large and persistent ‘such as the 2008 ‘crisis’’ will keep inflation away from target for longer periods. But, external factors have meant that prices have continued to increase despite weak economic conditions. The bank has dubbed these ‘exceptional circumstances’, and in response has co-ordinated ‘unorthodox policies’ i.e. quantitative easing, funding for lending and now forward guidance. These policies all aim to support economic output whilst accommodating for inflation which persists above the banks target rate.
What can forward guidance achieve?
Under current circumstances a more forward looking strategy should ease undue volatility in the way agents form expectations about future bank policy. It should provide greater clarity about the MPC’s view of the appropriate trade-off between the horizon in which inflation is returned to target and the speed at which growth and employment recover.
The Bank has made clear that the inflation mandate is still firmly in place, and remains the primary influencing factor over MPC decisions. A set of ‘knockout’ criteria have been determined which could lead to an abandonment of the unemployment target if any of them are ‘breached’.
The unemployment target could be abandoned if; inflation is likely to remain 0.5% above the target for longer than 18-24 months, if medium-term expectations of inflation become unanchored or if the monetary stance poses a threat to financial stability.
Implicitly, forward guidance is likely to act through three channels; it will manage short-term inflation and interest rate expectations, it will reduce unnecessary short-term volatility in expectations about medium term interest rates, and will influence the level and volatility of short-term risk free rates, boosting asset prices and reducing firms borrowing costs.
The 7% unemployment target
Targeting a particular variable such as unemployment is referred to as state contingent guidance, which implies that the monetary base (the money supply that the bank can influence) is maintained or increased until the target is reached. The MPC determined that the unemployment rate is the most suitable indicator of activity given the present uncertainties about the evolution of supply and the amount of slack in the economy.
Other alternatives for the target such as nominal GDP or the output gap were rumoured prior to the announcement. The Bank concluded that unemployment is less volatile than these other options, it is not prone to substantial revisions and it is widely understood. Yesterday the bank made clear that the 7% rate is a threshold not a trigger, and a subsequent autonomous rate rise will not occur when 7% unemployment is achieved.
What happens after the 7% unemployment target is reached?
“7% does not represent the MPC’s view of the lowest sustainable rate to which unemployment can fall”
The Bank estimates that the equilibrium unemployment rate is 6.5%, which reflects institutional features of the labour market which cannot be augmented by monetary policy; however, monetary policy can help return unemployment from its current rate of 7.8% to the equilibrium rate (long term trend).
“To ensure that CPI inflation remains on track to return to the 2% target, the committee will need to withdraw some of the monetary stimulus before the unemployment rate falls back to its medium term equilibrium…when this occurs the MPCs decision on the Bank Rate will depend on individual member assessments of the ‘knockouts’”
And finally…..It’s all about credibility!!!!
In the long-term, the delivery of low and stable inflation remains the best contribution the bank can make in enabling the UK to achieve long run growth and prosperity. The Bank has reaffirmed this in announcing the three ‘knockout criteria’. Still, in order to deal with the short and medium-term issues, another target, namely unemployment should be useful.
The effectiveness of issuing short/medium-term guidance requires complete credibility. Most important, now that the unemployment target is in place, should unemployment increase, the bank will surely have to take policy action, even at the expense of stoking short-term inflation, or otherwise risk a significant loss of credibility, potentially rendering guidance useless.