Conditional credibility

With interest rates trapped at the lower bound central banks have in recent years adopted a policy of forward guidance to help markets interpret what they were likely to do in the face of the incoming data flow. Its success has been mixed. Recall the bond market “taper tantrum” in 2013 when the Federal Reserve announced that it was about to slow down the pace of asset purchases - though in fairness, this was more the result of a market which panicked rather than the fault of the central bank. But so far this year the Fed has more or less adhered to the message contained in the dot plot (see p3 here) despite the market’s initial scepticism.

Arguably, the Bank of England’s efforts at forward guidance have not been quite as successful, and in a week of important UK data releases which may determine whether the BoE will soon raise rates, it is important to understand the nature of the forward guidance message. In August 2013 the BoE pledged “not to raise Bank Rate from its current level of 0.5% at least until … the unemployment rate has fallen to a threshold of 7%.” The BoE was clear that this was a conditional target, subject to (i) CPI inflation 18 to 24 months ahead no more than 0.5 percentage points above the 2% target; (ii) medium-term inflation expectations no longer remaining sufficiently well anchored and (iii) the stance of monetary policy posing a significant threat to financial stability. Even though unemployment fell more rapidly than the BoE – and indeed, most other forecasters – anticipated, none of the knockouts were ever triggered. Thus although policy was conditional, it was never fully clear why the BoE did not raise rates once the unemployment rate fell below 7%. Good arguments could be made for leaving rates on hold but it rather defeated the purpose of the forward guidance framework.

By February 2014 the BoE abandoned the simple mechanistic link between monetary policy and unemployment in favour of a less easily defined policy based on the nebulous concept of spare capacity. Since the measure of spare capacity was determined by the BoE, this meant that outside observers became increasingly reliant on the information feed from the MPC to determine the future policy stance. The clarity of rule-based forward guidance policy was lost. Later in 2014, at his Mansion House speech, Governor Carney suggested that the first rise in interest rates “could happen sooner than markets currently expect.” It didn’t. And to this day it is difficult to explain why the rate hike did not happen other than the fact that the BoE simply did not want to act before the Fed.

Last month “a majority of MPC members judged that, if the economy continued to follow a path consistent with the prospect of a continued erosion of slack and a gradual rise in underlying inflationary pressure then, with the further lessening in the trade-off that this would imply, some withdrawal of monetary stimulus was likely to be appropriate over the coming months.” We know from this morning’s parliamentary testimony that two Committee members (Dave Ramsden and Silvana Tenreyro) are not part of that majority. We also know that four other members appear to be edging towards an earlier rate increase whilst the view of the other three is unknown.

Arguably, given the clarity of the message given in recent weeks, the MPC needs to deliver sooner rather than later after having left markets hanging in the past. Of course, “coming months” does not necessarily refer to November (the next month in which an Inflation Report is released) – it could just as easily be February (the following Inflation Report month). But the fact that little has been done to dissuade the market of this view suggests that November would be a good time to act. Leaving the door open until February runs the risk that events could transpire which change the Bank’s priorities, and despite the conditional nature of the policy decision, markets will see this as another occasion on which it has cried wolf.

Policy credibility remains important to policymakers. An absence of such credibility defeats the purpose of forward guidance. Whilst the BoE can justifiably argue that forward guidance is conditional on economic circumstances, it cannot continue to hide behind the Augustinian clause forever (allow us to raise interest rates, but not just yet). Whether or not it is the right time to consider a rate increase is almost irrelevant – my own view is that the recent surge which has taken CPI inflation to 3% is not a good justification for a policy tightening, driven as it is by a one-off sterling depreciation. However, what matters is the consistency of the message. The markets are hearing a very clear message: It would require a lot of explanation on the BoE’s part if it were to pass up on a rate hiking opportunity.