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.

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