This article is part of Morningstar's "Perspectives" series, written by third-party contributors. Here, Kerry Craig, Global Market Strategist, J.P. Morgan Asset Management discusses the future of interest rates.
What a difference six months makes. It was just August that Bank of England (Bank) decided to implement forward guidance. Even then, investors questioned the validity of this policy and of the forecasts underpinning the pledge to maintain low policy rates. Turns out they were right to do so. Six months on and forward guidance could be for the scrapheap as the economy has improved markedly and the unemployment rate fallen far quicker than the Bank mandarins could have imagined. So where can the Bank go from here?
A brief recap. In August 2013, the Bank stated that it would keep the official policy rate at 0.5% until the unemployment rate fell to 7%. At the time, forecasts from the Bank suggested this would happen around the middle of 2016. What the Bank wanted to see was a gradual decline in the unemployment rate as productivity increased and the economy expanded. What transpired instead was that the unemployment rate plummeted from 7.8% at the time of the announcement to 7.1% in the three months to November, with the total number of employed increasing by 373,000. The jobless benefit claimant count figures included in the latest labour report suggest that the unemployment rate will continue to fall and that the unemployment rate may hit 7.0% in the next few months.
I have always argued that forward guidance was not the best policy, believing it did too much damage to the central bank’s reaction function – and, perhaps more importantly, put its credibility at risk. Almost as soon as the forward guidance threshold was announced the Bank was on the back foot, released a revised set of forecasts in November of last year and stating that the 7% level was a ‘staging post’ rather than a trigger for interest rate rises, and would merely indicate the point at which policymakers would re-evaluate the economy and decide the best course for monetary policy.
By implementing forward guidance that used the unemployment rate as a proxy for economic health and inflationary pressures, the Bank of England was following in the monetary policy footsteps of the US Federal Reserve. However, it has become apparent that the unemployment rate is an imperfect measure. In the US, structural changes to the labour market due to an aging population and earlier retirement of the baby boomers have caused a dislocation between the unemployment rate and the economy. Meanwhile, here in the UK, weaker productivity has meant the employment has grown faster than economic output.
The quarterly Inflation Report is becoming an increasingly important tool for the Bank to signal its intentions. The next report, due in February, may be the point at which the 7% threshold is finally put to bed. So what other options does the Bank have?
The threshold could be lowered to, say, 6.5%, giving the Bank more time to see if productivity does increase as it expects, but such a move would call into question the Bank’s forecasting abilities and may be seen as simply moving the goal posts, damaging its credibility. Alternatively, reference could be made to other economic indicators – wage growth, perhaps. But having more than one trail marker for the interest rate path could create as much confusion as clarity, as different data points can often point in different directions. A better option would be for the Bank to regain its focus on inflation targeting.
The rate of inflation fell back to the 2% target in December and the outlook for inflationary pressures is pretty mild. The stronger pound has made imports cheaper and the tighter labour market has yet to produce a big rise in wages that could drive prices higher. A renewed focus on inflation targeting could give the Bank a legitimate reason to keep rates on hold.
The Bank also has the option to make further use of macro-prudential policies, such as the Funding for Lending scheme. But tinkering around the edges of monetary policy with such tools could create a false sense of security about what policymakers can actually achieve.
With or without the use of forward guidance in its current form, rates aren’t going to rise in the near term because the recovery isn’t strong enough. How the Bank changes monetary policy to reflect this, and how it communicates its expectations to markets, will determine whether it can maintain its credibility.
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