Forward guidance: Mark Carney moves the goalposts

Bank of England governor Mark Carney has been forced to ditch his ‘forward guidance’ policy. Last summer, he warned the nation that he would only consider raising interest rates once unemployment had fallen to 7%.

At the time, that level seemed laughably distant – yet a rapid rebound in the UK economy has seen the jobless rate plunge so fast that it is already nearly at 7%.

So this week, Carney replaced the emphasis on unemployment with a broader focus on nurturing the recovery. The Bank will monitor ‘spare capacity’ – the amount of slack in the economy – which determines how fast it can grow without generating inflation. The Bank also revised up its official estimate for 2014’s GDP growth from 2.8% to 3.4%.

What the commentators said

“The Old Lady of Threadneedle Street has got her knickers in a twist,” said Stephen Fay in Australia’s Business Spectator. “Like almost every other forecaster, the Bank failed to predict the spurt away from recession” in the middle of last year, which had left many expecting rate rises quite soon. So the forward guidance that was supposed to bring clarity has had to be jettisoned and a new version found.

However, the worry is that by putting much more emphasis on the ‘output gap’, or spare capacity, the Bank is replacing the unemployment rate “with an even more unpredictable, and much less observable, economic concept”, said Capital Economics.

The output gap is notoriously difficult to measure in real time, and estimates of its size range from near-zero to around 6% of GDP. It is crucial to the inflation outlook, however.

If it is small, it means demand in the economy is close to matching supply, so growth cannot continue much longer without causing upward pressure on inflation. But if it is large, there is still plenty of capacity sitting around that was left idle in the recession, and the economy can grow into it without inflation rising.

Output-gap pessimists, such as Fathom Consulting, reckon the recession destroyed a lot of capacity – as opposed to simply leaving it idle – so the economy’s productive potential was shrunk.

As MoneyWeek has noted, studies suggest that recessions following financial crises tend to wipe out a lot of capacity, as all the lousy investments caused by loose credit are killed off.

Fathom is worried that inflation will soon be back and interest rates won’t rise nearly fast enough to tame it, fuelling the housing bubble and causing a “sterling crisis”. Another boom and bust disaster “is all too possible”, said Allister Heath in City AM. We will find out who’s right about the output gap in 2016 or 2017.

• Stay up to date with MoneyWeek: Follow us on TwitterFacebook and Google+

MoneyWeek magazine

Latest issue:

Magazine cover
Why you should worry about Greece

...and how to protect your wealth

The UK's best-selling financial magazine. Take a FREE trial today.
Claim 4 FREE Issues

From ADRs to Z scores – all the terms you wish you understood, but were too embarrassed to ask about.

Gervais Williams: if you want real dividend growth, buy small-cap stocks

Merryn Somerset Webb interviews small-cap stock expert Gervais Williams about how penny shares outperform blue chips 'again and again'.


Which investment platform is the right one for you?

When it comes to buying shares and funds, there are several investment platforms and brokers to choose from, with varying fees and charges. Find out which is best for you.


2 July 1928: Women given equal voting rights with men


On this day in 1928, the Representation of the People (Equal Franchise) Act extended equal voting rights to women, lowering the voting age to 21.


Anatomy of a Grexit: how Greece would go about leaving the euro

Jonathan Loynes and Jennifer McKeown, economists at Capital Economics, look at the key issues and challenges of a Grexit, how it might be best managed, and set out a timetable for change.