Carney likely to mimic the Fed, but is policy guidance the silver bullet? AXA’s Mark Allan comments
Mark Allan, senior economist at AXA Investment Managers, discusses the policy challenges facing the future Governor of the Bank of England after the Fed comments.
“At the beginning of July, Mark Carney takes over from Mervyn King as Governor of the Bank of England. Earlier this year, Carney said he believed it was the responsibility of central banks to use monetary policy to ensure economies reach ‘escape velocity’. Exactly what ‘escape velocity’ will look like no one is quite sure, but it is safe to say that the current consensus forecast for UK growth of less than 1% this year followed by 1.5% next year is certainly not it.
“Assuming Carney can convince his fellow MPC members to ease policy further, there are a number of options open to him. These include further gilt purchases, buying private sector securities, additional credit easing initiatives, policy commitment/guidance strategies and cutting interest rates. Of all these options, Carney’s clearly expressed preference is for interest rate policy guidance, a tool with which he has prior experience of. In March, the government instructed the Bank to publish its views in the August Inflation Report (due on 7 August) about how guidance policies might work in the UK. This makes the August MPC decision six days beforehand, the earliest plausible option for such a change in policy.
“If a Carney-led BoE is to introduce some form of threshold guidance over the outlook for interest rates, an obvious question is: what form should that threshold take? There are essentially two options. The first is to mimic the Fed and use unemployment and medium-term inflation. The second is to target either the level or growth rate of money spending, aka nominal GDP. On balance, it seems more likely the Bank will opt to tie any policy guidance to the unemployment rate. This has one important advantage: the concept of unemployment is well understood by people and markets, unlike nominal GDP, making explanations of the policy framework easier. Although there is plenty of uncertainty about the supply side of the economy given a prolonged period of weak productivity, opting to commit not to raise rates until the unemployment rate is somewhere in the range 6.5% to 7% shouldn’t pose too many risks to the long-run inflation outlook. Whether the Bank chooses unemployment or nominal GDP as its anchoring point for policy, one thing it will inevitably have to do is begin publishing forecasts of that variable. Without them, market understanding of the policy is likely to be limited.
“Theory argues that for these commitment type strategies to work they have to be believable. That limits the type of guidance strategy that can be adopted. We believe that guidance strategies are at their most useful at turning points in the monetary policy cycle. The UK recovery is still some way behind that in the US; expectations of the first UK rate hike are still 2 years away. It’s possible that guidance from the BoE can help push that date out a little further but, as a major source of policy loosening in the current conjuncture, it seems unlikely to suffice on its own. Once the UK recovery starts to gather some steam (hopefully sometime early next year), then guidance will likely prove more powerful by preventing market interest rates from rising too sharply and choking off the recovery.
“Carney is likely to have to work hard to overcome internal BoE opposition to loosening policy, but it would be a surprise if he were to be unsuccessful.
“The intellectual framework of monetary policy under Mervyn King was to look at the economy each month and set policy completely afresh each time. Any believability that policy had was stretched to breaking point once the Bank began QE and set itself multi-month targets for the amount of gilts it sought to buy. Under Carney the Bank seems set to kill off that month-by-month approach to policy by formally tying interest rate decisions to the outlook for the economy. Guidance seems likely to provide some modest further support to the economy, but should growth slip back down towards zero more radical options are likely to be needed to break the economy out of its stupor. More radical interventions in the banking sector might be a place to start.”
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