Some forward guidance on forward guidance

The Chancellor George Osborne has asked the Bank of England to produce a report on forward guidance in time for the August inflation report. Forward guidance is in fashion. It has been used by the US Federal Reserve since 2008, and more recently the European Central Bank has offered some guidance on monetary policy.

As the new Governor of the Bank of England, Mark Carney is obligated to produce a report for the Chancellor of the Exchequer on forward guidance. Below I consider some of the issues and key challenges that will be faced in developing monetary policy on this basis.

What is Forward Guidance?

Forward guidance is the release of information about when and under what conditions the Bank of England may feel obliged to lift the level of base rates in the economy, as the period of Zero Interest Rates (Life on Planet ZIRP) comes to an end.

The Bank of England has the responsibility to maintain price stability around the 2% level. But with inflation above target, the Bank has been more concerned about the recession, lost output, job losses, unemployment and the lack of growth in the economy, rather than trying to hit the elusive inflation target by increasing interest rates. Base rates have been at the “zero bound” or thereabouts at 0.5% (50 basis points), since March 2009, but with inflation above target and with the economy showing signs of recovery, the question becomes: when will rates rise and by how much?

Forward Guidance and Intermediate thresholds

Using intermediate thresholds, the Bank's MPC would inform the markets that base rate would be kept at the historically low 0.5% for a certain minimum period of time. Or, they could be held until certain conditions in the economy have been met - for example, a fall in the unemployment rate to a certain level. Ben Bernanke has suggested an unemployment rate of 6.5% could lead to an end of the end of an easy monetary policy in the USA. Below, we consider if the same target would work in the UK.

What's the point of Forward Guidance?

Central Banks believe that if consumers and businesses can be convinced that base rates will be on hold for some considerable period of time into the future, spending or investment plans will be brought forward to benefit from the lower rate.

However, some commentators are not entirely convinced by this argument. With inflation above target and likely to remain so, businesses realise that as the economy recovers, interest rates will begin to rise sooner or later.

If growth is faster, the sooner the rates will rise. If growth is slower, the rate rise will be delayed. The irony for business is the cost of capital is only a small part of the investment payback proposition. Demand is far more important. Rising demand will lead to a rise in rates but the payback will be better, despite the rise in the “cost of money”. The converse is also true. Lower demand may mean that rates will be on hold for longer. Capital may cost less but returns from limited growth are lower, therefore investment plans may be kept on hold, irrespective of the timing of an increase in rates.

How does the Bank decide what conditions to set?

At the moment we don’t really know what parameters will be chosen by Mark Carney as the new governor. It could be a promise not to raise rates for a period of time, or not to raise them until unemployment falls back below a certain level, perhaps 6.0%. Alternatively, rates could be on hold until the economy's output gap - a measure of the country's under utilised capacity - is eliminated by growth in the economy.

The Output Gap

The problem with the “output gap” measure, is that we have no way of knowing what the gap is. We cannot identify, measure or quantify, the output gap, let alone use this as a policy parameter.

One option is to measure the output gap relative to the average rate of growth of the British Economy over the long term and estimate the output gap relative to trend. Using a long run average of 2.4%, the output gap at present is around 10%. Growth in the economy would have to be significantly above the long term average for a considerable period of time, before the gap closed completely.

It would take seven years of growth at 4% to close the output gap! Can we really believe that with inflation above target and with growth at say 4.0%, we will wait seven years for base rates to rise? Of course not! The output gap would create great problems if used as an intermediate threshold.

Forward Market Guidance

In the May Inflation report, the Bank of England was happy to use forward guidance derived from the financial markets. Complex swap data suggested base rates would not begin to rise until 2016. Subsequently, following statements by the Federal Reserve, gilt yields started to rise and the UK OIS swap data implied UK base rates would begin to rise in 2015. The Bank of England was unhappy with this and gave clear indications that market perceptions were at odds with intentions. As the swap curve returned to the 2016 gradient, implying rates would not increase until 2016 - calm, amongst the MPC members at least, resumed.

Historically, forward rates have provided little guidance as to the future direction of base rates. Nevertheless, used as a rough guide, the comments by the Bank of England have been effective in providing some steer. Using the OIS template, forward swap rates could be used as a benchmark for comment and direction - a sort of rough time line.

Unemployment Rate

Should the Bank of England use the unemployment rate as an intermediate threshold? In this scenario, base rates would increase only when the economy recovers and unemployment falls to a certain level. Assuming the unemployment level target is set to 6.5%, (the rate below which base rates may begin to rise), then we have to ask, what will drive the reduction in unemployment? The answer of course is growth. Using standard models of growth and job creation, assuming a trend rate of growth of say 2.5% from 2014 onwards, unemployment would hit a level of 6.5% in 2017. That’s one year beyond the current time frontier identified by the swap rate forecasts. A more modest recovery rate of 2% would see rates on hold until 2019 before the 6.5% unemployment target is met. But with inflation above target, base rates may have to rise long before this to combat inflation.

Forward Guidance - is not an easy option

Whatever guidance the Bank of England may provide in the short term, the Old Lady of Threadneedle Street will always have the legal right to change its mind later. Indeed, it is mandated to do so if inflation gets out of hand. Can Mark Carney come up with a sensible set of rules on forward guidance and make a careful selection of suitable intermediate thresholds? It will not be easy. In any case, what is the value of forward guidance if the Bank can change its mind in the future? Forward guidance can easily become misdirection. Mervyn King was always set against the use of forward guidance, on this particular matter he may well be proved right. We look forward to the deliberations of the New Governor in August.
Originally published on the GM Chamber of Commerce Web site1st August 2013

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