LAST summer Mark Carney brought to the Bank of England a winning smile and the latest monetary fad. In August the bank unveiled “forward guidance”, modeled on action taken by America’s Federal Reserve, in an effort to buoy up Britain’s recovery. Markets should not fear looming rate rises, the bank explained: so long as inflation and financial markets behaved, the bank’s main policy rate would not go up until unemployment fell to at least 7%. The economy responded obligingly; since August it outperformed the Bank of England’s projections on almost every measure. Yet as Mr Carney prepared to unveil the bank’s February inflation report, he was hounded by arguments that guidance had failed and should be scrapped.
The bank’s main error was one of prognostication. The unemployment rate tumbled much faster than projected back in August. That, in turn, led to allegations the bank gave a misleading impression of how long rates would remain low. Not so, Mr Carney’s defenders countered; despite a booming economy markets expect no rate rise until early 2015. Without the bank’s promise, sinking unemployment would surely have markets looking for increases any month now. On February 12th, the bank rolled out its “next phase” of forward guidance, hoping to eliminate confusion.
The bank’s latest inflation report judges guidance a clear success. A majority of firms and households reported greater confidence as a result of the policy, according to figures in the report. In comments to the press Mr Carney seemed pleased to recount how thoroughly the British economy exceeded expectations. The bank sees more good times ahead. It now reckons Britain is on track for roaring 3.4% GDP growth in 2014, much better than the 2.6% market consensus.
The Bank of England hopes updated guidance will help deliver the goods. With unemployment expected to drop below 7% this spring, it is shifting focus to a broader measure of economic health: “spare capacity” in the economy, or room to raise GDP without sparking higher inflation. The bank aims to eliminate it within three years. The statement gives the bank some wiggle room, as it will publish its own estimates of the remaining shortfall. Yet Mr Carney seems to have outdone peers at other rich-world central banks in setting both a clear destination for the economy and an expected time of arrival.
The unemployment rate will remain on the bank’s dashboard; it should fall to 6-6.5% as the economy closes an estimated output gap of about 1-1.5% of GDP. (Longer working hours will also help.) But more than a dozen other measures, including wage growth and productivity, will also be monitored for signs the bank has over- or underestimated potential.
Communication about the path of bank rate has also improved. The output shortfall must shrink before a first rate rise, and eventual increases will be gradual and in line with published estimates of spare capacity. Even after rates have “normalised”, according to Mr Carney, they will settle at a level below historical norms. That is down to global headwinds, including weak demand and busted balance sheets, that may discourage investment.
This particular evolution of forward guidance is not without risks. What the Bank of England has given markets in detail has come at the cost of simplicity; no longer is there the single point of focus the unemployment threshold provided. Mr Carney will nonetheless hope his intentions are clear enough. “The MPC will not take risks with this recovery,” he stressed, with Canadian intensity. The bank must hope British firms will bet on it.
via:http://www.economist.com/blogs/freeexchange/2014/02/forward-guidance