This article is part of Morningstar's "Perspectives" series, written by third-party contributors.
In his first act as Bank of England governor in August 2013, Mark Carney formally introduced forward guidance to the Bank’s toolkit. The Bank committed to not increasing interest rates at least until unemployment fell below 7%, at the time it was 7.7%. There are two important features of this form of guidance: first, it links policy to the state of the economy; second, it commits the Bank to a particular path of policy.
This is sometimes known as state-contingent Odyssean guidance, because it ties the hands of the central bank. The idea is that this can help to provide extra stimulus when interest rates can’t be pushed any lower, by reassuring people that even when the economy recovers monetary policy will not be tightened rapidly. As the economy recovered, and the Bank started to consider tightening monetary policy, the form of guidance it used changed significantly.
From February 2014, the Bank started saying that it expected the equilibrium level of interest rates to remain lower than the past and, as such, it expected its hiking cycle to be “limited and gradual”. This is sometimes known as Delphic forward guidance, as it only amounts to a forecast rather than any sort of commitment or promise.
This “limited and gradual” guidance still underpins the Bank’s policy stance, and is meant to help clarify the Bank’s reaction function and reduce uncertainty in the path of rates. Along with this guidance about the broad path of rates, the Bank also tends to provide Delphic guidance about the timing of its next policy move. For example, in July 2015, Carney hinted at a rate hike “around the turn of the year”, and the minutes of its September 2017 meeting noted that “some withdrawal of monetary stimulus is likely to be appropriate over the coming months”.
It is this form of guidance that seems to get most attention, especially as the Bank has typically not followed through on this guidance. This “inaccuracy” has seen Carney called an “unreliable boyfriend” by some, and, more seriously, may hurt the Bank’s credibility, especially as the point of Delphic guidance is to reduce uncertainty. However, there is nothing necessarily wrong with policymakers changing their minds as the economy evolves.
True credibility ultimately comes from doing the right thing to meet objectives, not following through on guidance that may no longer be appropriate. Thus, it is often far more important to watch the evolution of data rather than the utterances of individual policymakers in predicting monetary policy. And on the basis of the recovery of UK data in the second quarter, we continue to expect the Bank to hike rates again in August.
The Bank of England provided another form of guidance at its last policy meeting, signalling that it planned to start the process of running down the size of its balance sheet when Bank rate reaches 1.5%. Not only does this provide explicit guidance about balance sheet policy, it also provides some guidance about how low the Bank thinks interest rates can fall.
When the Bank thought 0.5% represented the lower bound for rates, it suggested balance sheet unwind would start when rates reached 2%. This new guidance seems to imply the Bank now thinks 0% represents the lower bound, which may turn out to be significant in future downturns.
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