Sunday, August 11, 2013
Forward guidance aims to give the recovery time to flower
Posted by David Smith at 09:00 AM
Category: David Smith's other articles


My regular column is available to subscribers on This is an excerpt.

They may not be everybody's cup of tea but it has been my privilege to be present at some big Bank of England announcements.

In May 1997, I was among journalists invited to the Treasury for the announcement of Bank of England independence. Handing interest rate policy from the Treasury to the Bank was momentous.

Last week I was among journalists at the Bank for another momentous announcement, the forward guidance that Mark Carney has persuaded his monetary policy committee (MPC) colleagues to adopt. Not as big as independence but still a big deal.

The contrast with 1997, not to labour it, is interesting. Then, in response to a strongly growing economy, the Bank embarked on a series of interest rate hikes to establish its anti-inflation credibility.

This time, despite evidence recovery is gathering momentum, the Bank’s clear message was that rate hikes are a long way off. Indeed, on present plans the MPC will not even think about them for three years.

I will come on to recovery evidence but that, in a nutshell, is what the Carney-run Bank’s new policy is about. Growth is picking up and the first thing markets do when that happens is price in rate hikes.

The Bank’s clear message is that the recovery will be given time to mature, to achieve “escape velocity” from the doleful influence of the global financial crisis.

Is it the best-designed policy in the world? No. Frankly, it looks as it was designed by committee, which it was. The unemployment rate threshold of 7%, at which point the MPC will start thinking of higher rates, suffers from familiar flaws.

This week will almost certainly see a jobless rise because of the volatility of the monthly numbers. Since mid-2009 nearly 1m more are in jobs, yet the unemployment rate has only edged down from 7.9% to 7.8%. Older workers staying in jobs and inward migration could mean 7% unemployment is further than three years away. In the 1990s the rate only fell below 7% as the Bank hiked rates in summer 1997.

The three “knock-outs”, which could persuade the MPC to raise rates sooner, look like playful sparring. The Bank’s financial policy committee could declare that low rates threaten stability but it, like the MPC, is chaired by Carney and there is membership overlap.

The MPC itself could predict a “knock-out” inflation rate of 2.5% or more but its default position is to forecast 2%, in line with the target. Having seen inflation expectations move around a lot in recent years, the MPC is unlikely to shoot itself in the foot by suddenly concluding expectations were no longer “well-anchored”.

Without the knock-outs, of course, people might have concluded the Bank had given up on inflation. But they cloud the simple message that the Bank will seek to hold rates at 0.5% until recovery is well-established (making this the longest period of unchanged rates since 1939-51).

Will recovery become well-established? Since we had news in April that Britain had avoided a triple-dip recession, followed by the revising away of the earlier double-dip, surveys and numbers have been overwhelmingly stronger than expected.

So 0.3% first quarter growth gave way to 0.6% in the second and, to judge by the surveys, something even stronger in the third. Official figures for manufacturing showed an encouraging jump in June and retail sales showed a healthy rise in July.

The really striking evidence, however, is from the surveys. The July purchasing managers’ surveys showed manufacturing, construction and services all growing, as they did in the official data for second quarter GDP, but more strongly.

The manufacturing purchasing managers’ index showed its strongest growth in 28 months and construction output picked up to its fastest rate since June 2010. Most spectacular of all was the service sector, its July index reading of 60.2 pointing to the fastest increase in business activity since late 2006.

Another survey, the KPMG/Recruitment and Employment Confederation report on jobs, also from the information provider Markit, showed the biggest increase in permanent jobs since March 2010 and the strongest rise in vacancies for six years.

Why is it happening? We are seeing a frequently-made claim of recent years, that Britain could never recover alongside a fiscal tightening, disproved. More on that in coming weeks. Growth was held back by several factors and some are now easing.

So the eurozone appears to be coming out of its second recession in five years, with important implications for British exports and business confidence. The flow of credit to households and businesses, while still weak, is starting to improve.

Even the squeeze on real incomes is easing. The gap between wage growth and inflation is narrowing and individuals are benefiting from the coalition’s increases in the personal tax allowance. Consumer and business confidence has risen, a necessary precondition for stronger growth.

Does it matter what kind of recovery we have? Yes, but in the early stages beggars cannot be choosers. There is a lot of nonsense talked about lack of rebalancing - the trade deficit in the first half was down by a third on a year earlier - and even more about housing market bubbles.

After three years in which everybody has bemoaned lack of demand in the economy now some worry that - horror of horrors - some of it is coming from consumers. The bald fact is that if you do not have a recovery in consumer spending, two-thirds of GDP, you do not have a recovery. I believe the Bank when it says stronger investment will follow, and an apparent downward lurch in the saving ratio in the first quarter reflected distortions that will be reversed in the second.

None of this has much to do, yet, with forward guidance, but by heading off talk of higher rates, even when growth rises above 2.7% (on Bank forecasts) in the early part of next year, it will nurture recovery.

If growth accelerated much more than this, even if unemployment stays high, the Bank has to be alert. Forward guidance is just that. In an uncertain world the path of interest rates can never be set in stone. And a rise in rates can be good news, showing the economy is strong enough to take it.

Inflation also still matters and any repeat of the experience of recent years, when on two separate occasions it has breached 5%, would be fatal for the credibility of the new policy.

The oldest cliche about monetary policy is that central bankers have to be ready to take away the punchbowl just as the party gets going. Carney intends to leave that punchbowl in place for some time. At some stage he will have to take it away. Judging when to do that will be the hard part.