Interest Rates Unravelled

Graham Carn’s special report on interest rates

So the speculation over interest rates is over (for the time being!) – but where does it leave ‘forward guidance’? Now SBT Financial Editor Graham Carn digs into the topic in this special report.

Amid increasing speculation that interest rates were going to rise this year, as a result of faster than expected falling unemployment, the Bank of England Governor Mark Carney has revisited the Bank’s interest rate policy to reduce the focus on purely unemployment figures and balance it more broadly with the economic recovery.

Governor Carney’s February statement asserted that the Bank’s forward guidance policy “is working” and had helped to secure growth but the Bank’s interest rate policy will now be determined not just by unemployment, but by a wider range of indicators. He also added that the recovery was not secure and that when rates rose, they would do so only “gradually”. Investors and analysts took this as an indication that rates would now rise next year, and there was an immediate strengthening of the pound on the money markets.

Introducing the Bank’s forward guidance policy last August, Mr Carney then said that the Bank would not consider raising interest rates from their current low of 0.5% until unemployment had fallen to 7% or below. This policy was designed to reduce uncertainty and encourage businesses to hire and spend.

Sticking to his innovative policy the Governor gave the assurance that “Forward guidance is working – expected interest rates have remained low even as the economy has recovered strongly, uncertainty about interest rates has fallen, and most importantly, UK businesses have understood the message.” However, he added that the policy needed to be revisited “as a result of exceptionally strong jobs growth”. “The unemployment rate has fallen much faster than anticipated… and is likely to reach 7% by the spring” he said.

The Bank’s latest inflation report also stated that the “Bank rate may need to remain at low levels for some time to come” and Katja Hall, Chief Policy Director of the CBI Business Group “Forward guidance has clearly been effective in influencing companies’ expectations of when interest rates will rise and in cementing their confidence in the recovery” but “the Bank’s new guidance will give businesses further peace of mind that interest rates will stay low for some time, until investment and incomes are growing at sustainable rates.”

It does not seem unreasonable to argue that forward guidance, in the form it was sold just a few months ago, is in the dustbin of monetary history”

Outlining the Bank’s revised forward guidance policy, the Governor said the Bank would now be looking at a wider range of indicators, including wages, productivity and spare capacity within the economy. “We have taken stock” he said. “We’re still looking to maintain the momentum of the recovery, but we have to make more nuanced judgements.”

The Bank will be producing forecasts on a range of indicators, and these will be based on market expectations of 2% interest rates by 2017 and a first rise in spring next year. “On the basis of the economy following the Bank’s expected path, the first rate increase is now pencilled in for the spring of 2015,” said Chris Williamson, chief economist at Markit. “Rates are then projected to rise to 2% by early 2017. Beyond 2017, the message from the Bank is that even when the economy has returned to normal… the appropriate level of Bank rate is likely to be materially below the 5% level set on average prior to the crisis”.

While highlighting the UK’s improved economic performance, Mr Carney said there was still a great deal of work to do to secure the recovery. “Households are saving less and spending more, and business investment is likely to gather pace this year”. As a result of this improved outlook, the Bank has increased its forecast for growth this year for the UK economy to 3.4% from 2.8%.

However, Mr Carney also warned that the recovery was “neither balanced nor sustainable”, and highlighted the fact that economic activity was still below pre-financial crisis levels. He added that productivity growth had been disappointing. “A few quarters of above trend growth driven by household spending are a good start but they aren’t sufficient for sustained momentum,” he said.

So what does this all mean for ‘forward guidance’?

The most important thing the Governor has now said is that the interest rate the Bank controls, the Bank Rate, will not be raised for some time and could still be as low as 2% in 2017. For Bank watchers, perhaps more important is how he has ditched the simple revolutionary system of so-called forward guidance on the future path of rates, introduced only last summer, for a more complex and fuzzier approach.

The previous statement last August had left room to manoeuvre but the markets were increasingly speculating on an immediate earlier rise in interest rates once the unemployment rate fell below 7%. That speculation was seen as not being helpful for business so with the 7% threshold set to be breached in the coming months, considerably earlier than the Bank had originally expected, the Governor is now saying that rates won’t be raised till the slack or spare capacity in the economy is on its way to being eliminated.

Mark Carney wants this to be seen as a bold statement, that the Bank remains committed to supporting further falls in unemployment and long-delayed improvements in living standards. Some may see it as almost a political statement to a hard-up nation that the Bank is on its side. However, it is slightly less clear what it means in respect of monetary policy and economics. The Bank has published an estimate that the economy currently has spare capacity equivalent to up to 1.5% of GDP or national output and it says at least half this gap is due to people being unemployed or under-employed, and that it does not expect the gap to be closed for more than two years.

This supports Carney’s ‘commitment’ that money will remain very cheap, that interest rates will remain at historic lows for years, but he also categorically refuses to give any kind of binding commitment to keep rates low for a specific period. He also concedes that the Bank’s estimate of the output gap and the rate at which it will close are bound to be wrong!

The big change between Carney’s Bank of England and that of his immediate predecessors is that they refused to talk about what they thought the future path of interest rates would be, whereas he relishes making non-binding, very general statements that interest rates should remain low – unless the Bank of England’s view on spare capacity turns out to be wrong. That feels like a cultural difference, and maybe it is economically significant, if somehow businesses and households take confidence from it and therefore invest and spend more. However, the Bank of England priority remains the same as it ever was, to keep inflation at more or less 2% over the forecasting time horizon (albeit that since 2009, and till recently, this was a target consistently overshot). Therefore the moment that the Monetary Policy Committee were to conclude that inflation was rising above 2% in a sustained and dangerous way, interest rates would rise. That judgement would be made in more-or-less the same way today as it would have been under Carney’s predecessors – on an assessment of whether the economy was growing above capacity, bringing the risk of self-reinforcing rises in wages and other costs determined by domestic demand.

So Carney’s focus on spare capacity is not such a break with the past, and in that sense, it does not seem unreasonable to argue that forward guidance, in the form it was sold just a few months ago, is in the dustbin of monetary history. However, the way the Bank of England is now openly joining in on the debate, on the big issues in our economy, is a refreshing development. In my opinion it is a healthier way of proceeding, lessening more extreme speculation and providing clearer, authoritative, and balanced expectations upon which business and individuals can base their financial decision making.

Graham Carn, SBT Financial Editor. Graham is also the senior partner of Blackstones Consulting – any comments or questions on this article please email blackstones@btinternet.com