A few reactions to the Bank of England's new forward guidance policy:
The MPC’s Forward Guidance: So, as expected, the MPC (pdf) is catching-up with the Fed, in introducing forward guidance that looks very similar. There are two notable differences: the unemployment threshold is 7%, rather than 6.5%, and there is a caveat (which the MPC calls a ‘knockout’) about financial stability as well as a caveat about inflation expectations. The MPC has also committed to not cut back on its QE purchases as well as not raise interest rates until unemployment falls below 7%, provided expectations of inflation do not exceed 2.5% and these caveats/knockouts do not apply.
We should be grateful for small mercies. This does clearly show that the MPC is not targeting 2% inflation two years ahead regardless, which I have argued it seems to have been doing recently. It focuses on unemployment, which does at least marginalise the idea that there is currently no spare capacity in the economy. In addition, by saying they do not currently expect unemployment to fall below 7% before mid-2016, they have provided a forecast of interest rates of sorts. The 7% unemployment figure is ... just an upper threshold, and there is no commitment to raise rates if unemployment goes below 7%. To those in the Bank, where the regime has hardly changed since 1997, all this will seem like a big deal, even if to outsiders it seems less radical. ...
One additional thing has become clearer. By saying that, even with this new guidance, they do not expect unemployment to fall below 7% until 2016, the MPC has made it more transparent how prolonged this recession is going to be. Only two conclusions can follow: either high inflation is preventing the MPC from doing something about this, or they do not think they have any effective instruments left. If the first is true, that should focus discussion on whether consumer price inflation should be allowed to be such a tight constraint on growth. If the second, then why not turn to a proven instrument for stimulating demand?
P.W. at The Economist:
Guidance on forward guidance: Today was the day for Mark Carney. At last the new governor of the Bank of England and former top Canadian central banker could reveal what his big idea – providing a steer on future monetary settings – would mean in practice. The answer is that it is going to be quite complicated.
The headline is fairly straightfoward. The base rate will not be raised from 0.5% ... until the unemployment rate, currently 7.8% of the labour force, has fallen to 7%. That 7% rate is not a trigger: it will not automatically lead to monetary tightening. Instead it is a threshold...
Moreover, while the jobless rate remains above 7% the MPC will not reduce the extra monetary stimulus provided through quantitive easing - and may boost it. ...
That may sound clear enough, but there are three provisos, any of which may cause the guidance no longer to hold. The first “knockout” ... is if the MPC judges that inflation in around two years’ time will be half a percentage point or more above the 2% inflation target. The second is if medium-term inflation expectations “no longer remain sufficiently well anchored”. The third is if the bank’s financial-policy committee judges that the monetary stance poses a significant threat to financial stability...
Gauging the future intentions of monetary policymakers is always a guessing game. Forward guidance is supposed to take some of the uncertainty away and thus to promote a stronger recovery. But making a go of it in practice is tricky. The Fed’s recent attempt to set out when it might slow the pace of asset purchases has generated more heat than light. The complexity of the Bank of England’s version may mean that it will not achieve the clarity that Mr Carney is hoping that it will deliver.
Forward guidance to make existing stimulus ‘more effective’, ie more powerful?: The key question at the heart of the revelation of the new framework for the implementation of monetary policy is whether it constitutes a loosening of monetary policy, relative to what was envisaged before.
It seems inconceivable that there could have been a majority for a loosening of monetary policy: i) such a majority did not exist before Carney’s arrival, ii) the data firmed substantially since that point. To justify a loosening, MPC members would surely have had to put aside their obligation to vote individually, in favour of another objective to smooth the succession of the new Governor, perhaps worried that by not doing the credibility of his leadership, and so the MPC as a whole, would be threatened.
When asked at the Press Conference ... to clarify whether or not forward guidance was a loosening of policy, or just a clarification, although Carney chose to point out that it was primarily the latter, in doing this he emphasised that by so doing the existing stimulus would be made ‘more effective’. Most people would take that to mean ‘more powerful’. ... Hence it seems Carney at least expects the new framework to exert more stimulus, and given the convention that the Governor confines himself to speaking for the majority at the Press Conference, one would presume that the other MPC members also think this. But if that’s the case, how does one reconcile those MPC members’ previous votes. What has happened since those votes to convince them that they needed to make the stimulus they voted for previously ‘more effective’, ie ‘more powerful’? ...
Forward Guidance in the U.K.: Mark Carney's first major move as Governor of the Bank of England was to adopt what looks like a replica of the Fed's forward guidance policy, with some potential QE in the mix as well. As with the Fed, there are some contingencies associated with this:Carney said the unemployment target could be abandoned should the bank's internal analysis show GDP growth was the cause of a rise in prices of more than 2.5% in two years' time.
That's odd. How are we supposed to know whether a given change in GDP "caused" a given change in prices? What does that mean anyway? In a lot of macro theories, we think of exogenous shocks as driving endogenous variables - which are typically GDP, prices, etc. I guess you could write down a theory where GDP is exogenous, but that doesn't look like anything that serious macroeconomists take seriously. But what if you could write down such a theory? Then Carney seems to be saying that there might be things causing inflation other than GDP, and if those come into play, he's not going to get bent out of shape about it. More simply, I think we should interpret Carney as saying that he's going to tolerate inflation above 2.5% if he thinks the real side of the economy is weak. Forward guidance is a surefire way to confuse anyone, but Carney made this more confusing than it needed to be.