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Azad Zangana, European Economist, Schroders

BoE bamboozles with changes to forward guidance

Azad Zangana (pictured), European Economist, Schroders comments on the latest quarterly Inflation Report from the Bank of England…

As part of its quarterly Inflation Report, the Bank of England (BoE) has decided to expand its use of macroeconomic variables in its presentation of forward guidance. The previous 7% unemployment rate threshold would have been breached in the coming months, which has prompted the Bank to re-assess its communications strategy.

Rather than focusing on the unemployment rate, the Bank will now focus on estimates of spare capacity, which is largely measured through the labour market. This is very similar to the old ‘Golden Rule’ as introduced by Gordon Brown. Using measures of the economic cycle (and therefore spare capacity) to set targets. However, as has been proven in the past, estimates of spare capacity are highly uncertain and certainly subject to a large degree of discretion, which in our view can be manipulated to suit other objectives.
For example, one of the key indicators is the unemployment gap: the difference between the unemployment rate and the estimate of the medium-term equilibrium unemployment rate. The Bank currently believes that this gap is 1.2% – effectively setting a new unemployment target of 5.9%. However, this could be revised in either direction if there are signs that the medium-term equilibrium rate changes. For example, the Bank has noted that a larger than expected fall in the long-term unemployment rate (those unemployed for more than 12 months), which suggests that there is greater scope for the headline unemployment rate to fall further, as these long-term unemployed would have been considered to be less likely to gain employment.
Other key indicators include: total hours worked gap, average hours gap, vacancies to unemployment rate ratio, proportion of temporary workers unable to find permanent work and labour force participation gap. In fact, in today’s press conference, Governor Carney mentioned 18 new indicators to consider.
There is little doubt that the BoE has always considered every available indicator when assessing the degree of spare capacity, and therefore future inflation. However, the change in the Bank’s communication policy looks like a confuse and conquer approach. The Bank’s smoke and mirrors approach to forward guidance – which on the one hand will highlight the degree of complexity in setting monetary policy whilst on the other will thoroughly confuse the average person – will certainly introduce new uncertainty for their expectations on the future path of interest rates.
In our view, the information presented today highlights the Bank’s reluctance to raise interest rates. Carney highlighted the sharp appreciation in Sterling, and the impact that this has had in lowering inflation through imported prices. Conditioned on the market’s path of interest rates, inflation in the medium-term is below the Bank’s central target of 2%, which is a signal that the Bank thinks the market’s pricing of a rate hike in early 2015 as being too aggressive. Moreover, the Bank’s GDP growth forecast is a huge 3.4% for 2014 – a full percentage point higher than our own, and higher than any other forecast that we could find. Unless the Bank has spotted something that the market has missed, then we expect them to be forced to cut their growth forecast within months.
We are happy to stick to our forecast on interest rates being held until the start of 2016. The Bank now has at least 18 different variables it can point to keep interest rates on hold. The danger further out will be when inflation starts to rise again. We could be questioning the Bank’s credibility again as an inflation fighter, which risks de-anchoring inflation expectations. However, this is a distant problem as lower energy, food and imported prices should push inflation lower in the near term.

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