13 Feb 2014

Forward guidance did not fail, but welcome to forward vagueness

On any measure, having to abandon your much-hyped new policy innovation after just six months, is embarrassing. The rock star central banker seems out of tune.

Now I like a good u-turn story as much as anyone else. But Governor Mark Carney’s forward guidance policy can hardly be seen as a failure. Not yet.

The point of forward guidance was not to hit an unemployment target on a certain day. Mark Carney was trying to find a rationale, excuses you might call them, to keep interest rates lower than they should be under our conventional understanding of inflation targeting. There is no doubt that dotcom or credit boom rates of GDP growth (forecast at 3.4%), and record increases in employment are not consistent with emergency base interest rates of 0.5%.

The nub of this is what is known as “constrained discretion”. Monetary policy independence to achieve a rigid target for inflation is the foremost example of technocrats given discretion over policy, under the constraint of that target. The discretion allows the job to get done, the constraint provides market credibility that tough decisions will be made, when they have to be.

Bank of England Financial Stability Report Press Conference

Constrained discretion was considered such a success that it has been applied in fiscal, planning, minimum wage and health policy.

The point of forward guidance was to formalise the Bank of England’s powers of discretion over rate rises, and loosen the constraints of the past, without losing credibility. The rationale: the need to get households and businesses to feel confident enough to stop hoarding cash, and to spend, consume, invest and create jobs, after an epic balance sheet recession, and an existential geopolitical crisis in our neighbouring economic bloc.

Less constraint, more discretion. As the Governor told me in a press conference in August: forward guidance would make monetary stimulus “more effective”. How? By persuading households and businesses that “lower for longer” rates would not rise automatically to trip up any nascent recovery.

It was a powerful message, received more clearly in business boardrooms, than in markets or in people’s homes. That is what the surveys have shown. The PMI confidence measures have gone ballistic since mid 2013, pulling well ahead of the improving underlying economic picture. (The bank’s strong growth forecast is built on a punchy return of business investment, in turn, arising out of renewed business confidence its surveys do attribute partly to forward guidance). In the past you could pretty much map interest rate decisions with the PMI confidence barometer going up and down. Forward guidance was intended to break that link, temporarily.

Yesterday, Mr Carney dispensed with the unemployment threshold. The point of that was clarity of communication. It was a marketing ploy designed to inspire confidence. It was a conditionally fixed-rate interest rate for the economy. The BoE had never before forecast unemployment, and probably never will again. The threshold was reached within weeks not years. But the essence of the policy has not been abandoned, or ripped up at all. It has been, if anything, stretched.

The Bank is now targeting “spare capacity” something vague, arguably non-existent, and certainly not independently observable. In theory this will involve unemployment down to 6.5% and measures of “underemployment” such as part-time workers wanting to work longer hours, also reducing. It is no longer an exercise in simple communication and applied psychology, but in constructive vagueness.

The policy is not forward guidance. The policy is to maximise stimulus while coming up with a complicated rationale for maintaining credibility. In current circumstances, with solid growth, record employment rises, rates would ordinarily be going up. But phase 2 forward vagueness enables Carney to persuade markets and businesses that interest rates will not go up in 2014.

Three issues:
1. The committee. This exercise in communications would work better if Mr Carney was a monetary dictator. We will find out on Wednesday how much of a compromise this system was with the other 8 members of the MPC. Remember the 7% threshold with knockouts was itself a compromise.
2. Business investment: will it really return?
3. Bank credibility: are wages and prices really anchored by a credible central bank? Or are they in fact a function of deflationary pressures from China (2000s) or the eurozone (recently) coupled with the de minimis bargaining power of labour in Britain’s casualised, liberalised, weak union labour market? The British people have chosen jobs over wages. So perhaps the lionisation of monetary credibility is misplaced, and a more honest change of remit would be more transparent. Mr Carney would have had less bother now if George Osborne had gone for a nominal GDP target.

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