8th July 2013 by Shaun Richards
Last week saw a change in the policy of the Bank of England which came only a few days after its change of Governor. Readers of this blog will not have been surprised as last Monday I pointed out this.
It involves the central bank committing itself to a particular interest-rate for a certain period. This is the opposite of UK policy up to now where those involved with monetary policy avoid giving a view on the future course of interest-rates. I expect this to be the first change of the Carney era.
In a nice turn of phrase the Financial Times described this as a move from past open market operations to present and future “open-mouth” operations.
The actual announcement
There was something genuinely revolutionary and rare in the statement.
the (Monetary Policy) Committee noted that the incoming data over the past couple of months had been broadly consistent with the central outlook for output growth and inflation contained in the May Report
This is because over the credit crunch period the forecasting skills of the Monetary Policy Committee have varied between just plain wrong and appalling! Mind you it would take a fair bit more of this for them to raise themselves to the same level of the apocryphal monkey with a pin. However the intended change came here.
in the (Monetary Policy) Committee’s view, the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy.
This has been misinterpreted in much of the media in my view but if we stick to the statement the rationale presented behing it was this.
The significant upward movement in market interest rates would, however, weigh on that outlook
What is the Bank of England doing here?
It has used loose language to merge two concepts and it is in my view being misleading and giving an over inflated view of its own control over interest-rates.
What does the Bank of England control?
The Bank of England operates several times each day in the money markets and mostly does so through what are called repo operations which mature a fortnight later. So strictly speaking it controls interest-rates between overnight and a fortnight. You may note that technically speaking it does not actually control interest-rates until its next monthly meeting. In practice it has done so but we know in the credit crunch era that assuming such things can go awry.
Then the impact of its moves ripples out into the financial world. However even the Bank of England admits to limitations on its effect.
But these rates may not always move by the exact amount of the official rate change.
Also it can have complicated and indeed an inverse effect on the UK Gilt (government bonds) market.
the impact on longer-term interest rates can go either way.
The actual effect on long rates of an official rate change will partly depend on the impact of the policy change on inflation expectations
I have gone through this carefully because if the Bank of England admits that actual official interest changes have complex effects which vary depending on circumstances then “forward guidance” means what for our economy exactly? Frankly there is a danger of it becoming rather like the “masterly inaction” prized by the apochryphal civil servant Sir Humphrey Appleby of Yes Minister fame.
As the UK economy has had an official interest-rate of 0.5% for over four years now the prospect of it extending for another year or two is unlikely to have much impact, otherwise they are arguing that monetary policy is even slower than fiscal policy.
There are be a reverse current too
Should “forward guidance” otherwise known as making a promise about an uncertain future lead to a rise in inflationary expectations then longer-term interest-rates such as UK Gilt yields could rise in response. In fact UK economic history is littered with examples of this happening where economic policy has inverse and indeed perverse effects. Those of us who hoped that having monetary policy set by a (supposedly) independent central bank, as opposed to politicians, would allow us to escape that fate are facing yet more possible disappointment. The Monetary Policy Committee looked for a while as if it might have achieved “escape velocity” but since then it has crashed back to earth.
Indeed since the announcement at mid-day on Thursday the UK Gilt market has fallen and yields have risen. Or to be more specific after an initial knee-jerk rally which took our benchmark ten-year yield down to 2.32% we have see it rise to 2.48% at the time of typing. As ever there have been other forces at play such as the response to Friday’s US employment numbers the impact of which has ricocheted around bond markets, but there is food for thought in that after only a few days of “forward guidance” UK bond yields are higher rather than lower. Oops. Expressing this another way, our benchmark yield was below that of France but more recently has returned to being higher and is now 0.21% above the 2.27% in La Republique.
Indeed we have seen such a perverse effect in the United States where the “forward guidance” of December 2012 (on unemployment and inflation) has been followed by a rise of 1% in the ten-year Treasury Note yield.
The exchange rate
Here there also has been an apparent impact as on Wednesday the effective (trade-weighted) exchange rate of the UK pound sterling closed at 81 and on Friday it closed at 79.61. Those worried about any possible inflationary impact from the new announcement will be particularly worried by the fall below US $1.50. It was less than a month ago that we nudged above US $1.57 and now nudging above US $1.49 is an improvement on Friday.
This issue is exacerbated by the recent rise in oil prices due to what is happening around the Suez Canal which leaves the price of a barrel of Brent Crude up to US $107 but up more sharply in sterling terms to £71.81. Of course both moves may prove to be short-lived but UK economic innovations have ended this way before.
How did “forward guidance” begin to gain momentum?
In the late summer an economic conference is held at Jackson Hole in the United States and last summer Michael Woodford presented a paper which was something of a lifeline for increasingly desperate central bankers. Reality was intervening on their supposed Superman status (with apologies to Elizabeth Duke…). But here was a helping hand for interventionists.
But instead, I shall argue that the most eﬀective form of forward guidance involves advance commitment to deﬁnite criteria for future policy decisions.
Perhaps the most impressive part of this analysis was that he was able to extend it for forty-five pages! However central bankers around the world have lapped it up with the UK now taking the first baby steps towards it.
What could go wrong?
Actually the Michael Woodford paper hints at the fundamental problem at play here.
Does not prudence counsel that a central bank should speak as little as possible about what it might do under circumstances that it has not yet reached?
That is certainly my view and the issue is raised by what happens if the “forward guidance” proves inappropriate? We return to an issue which is particularly important at a time of uncertainty like this. As Ivan Van Dahl put it.
Please tell me why, do we build castles in the sky?
In essence the introduction of forward guidance is a contradiction of one of Mark Carney’s phrases as if monetary policy is not “maxxed out” why have we moved to “open-mouth” type operations?
There are of course those who will fear the new policy. Those who are savers will face the prospect of the current low savings rates persisting for longer. So just like as has happened with Quantitative Easing there are contractionary effects at play and they could yet swamp any expansionary effect. With wage growth so weak any inflationary impact would inflict even further damage on real wages and led to another contractionary force being at play.
I note that a member of the European Central Bank’s Governing Council Ewald Nowotny has called forward guidance a “historic step” today. The problem is in which direction…..?
Thnak you to those who wished me a good holiday and it is nice to see some sporting success too for these isles.