Role of forward guidance queried by economists

Economists have questioned the validity of the Bank of England’s forward guidance policy after it dramatically revised its August unemployment forecast.

The Bank’s inflation report, which came out last week, suggested there was a 50 per cent chance of joblessness falling to 7 per cent by the end of 2014, 18 months earlier than it estimated in August.

Under the Bank’s policy of forward guidance, the Monetary Policy Committee will not consider raising interest rates from 0.5 per cent until unemployment falls at, or below, this threshold.

Article continues after advert

However, governor Mark Carney was keen to stress that the 7 per cent level was “a staging post, not a trigger,” which would only result in a rate rise if other areas of the market were functioning at the desired level.

“What matters in the adjustment of monetary policy are the positions that exist at the point the threshold is reached,” he said, stressing that other factors, such as a pickup in productivity, would have to be identified.

The Bank introduced forward guidance earlier this year to expose the public to the thinking and criteria behind changes in monetary policy. But economists have said the strategy has been ineffective.

Simon Ward, chief economist at Henderson Global Investors, said the announcement made in the inflation report “reinforced the view that forward guidance is a waste of time”.

“As we have seen, the Bank of England has dramatically altered its unemployment forecast… anybody believing that interest rates will stay on hold until late 2015 is basing that view on very little,” he said.

The key problem was that forward guidance was brought in at the worst possible time for the economy, according to David Tinsley, UK economist at BNP Paribas.

“When they were introducing it, they [the Bank] were a bit unlucky that it was just when growth was picking up,” the economist said.

Mr Tinsley suggested there was a case for forward guidance in some form, because the market could have already priced in a rate rise from evidence of a strengthened economy had it not had reassurance from the Bank that it would hold off.

But picking the labour market as the most significant variable could have been a mistake, as it is “shifting quite quickly,” Mr Tinsley added.

“Perhaps a pledge to keep rates on hold for 18 months would have been better,” he said, as a “cut-and-dried approach” would have been more straightforward.

Jonathan Loynes, chief European economist at Capital Economics, said that while the inflation report provided “superficial support” for the idea that interest rates would rise sooner than expected, his projections remained more in line with the Bank’s as he believed excess capacity in the economy would mean rates stayed lower for longer.

But he noted the markets “never seemed to swallow the August report projections and have consistently priced in the first hike in interest rates in 2015,” which means that as unemployment falls further they will get increasingly jittery.