Forward guidance: Mark Carney moves the goalposts

Bank of England governor Mark Carney has replaced the emphasis on unemployment with a broader focus on nurturing the recovery.

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

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.

Recommended

Inflation: now we really have something to worry about
Inflation

Inflation: now we really have something to worry about

We’ve been worrying about a sharp rise in inflation for years, says Merryn Somerset Webb – now, we finally have something to worry about.
21 Jan 2022
UK inflation is at a 30-year high and it hasn’t peaked yet
Inflation

UK inflation is at a 30-year high and it hasn’t peaked yet

UK inflation has hit 5.4% - its highest in 30 years. And it could be heading higher. John Stepek explains what it means for you and your money.
19 Jan 2022
The UK jobs market is booming – but wages are struggling to keep up with prices
UK Economy

The UK jobs market is booming – but wages are struggling to keep up with prices

Britain’s jobs market is booming, with wages rising and plenty of of vacancies. But inflation is rising faster than wages can keep up. John Stepek loo…
18 Jan 2022
The difference between CPI and RPI inflation - and why it matters
Inflation

The difference between CPI and RPI inflation - and why it matters

The consumer price index (CPI) and retail price index (RPI) are both important indicators of inflation. But what is the difference and why do they mat…
17 Jan 2022

Most Popular

Shareholder capitalism: why we must return power to listed companies’ ultimate owners
Investment strategy

Shareholder capitalism: why we must return power to listed companies’ ultimate owners

Under our system of shareholder capitalism it's not fund managers, it‘s the individual investors – the company's ultimate owners – who should be telli…
24 Jan 2022
Ask for a pay rise – everyone else is
Inflation

Ask for a pay rise – everyone else is

As inflation bites and the labour market remains tight, many of the nation's employees are asking for a pay rise. Merryn Somerset Webb explains why yo…
17 Jan 2022
Three innovative Asian stocks to buy now
Share tips

Three innovative Asian stocks to buy now

Professional investor Fay Ren of the Cerno Pacific Fund highlights three of her favourite Asian stocks to buy now
24 Jan 2022