The Bank of England today released its quarterly inflation report, the first since Governor Mark Carney took the helm, alongside its update to the monetary policy framework. The report presents a more optimistic view of the UK’s growth prospects, with the Bank raising its GDP growth forecast for this year to around 1.4%, up from 1.2%, while upping its 2014 forecast to around 2.6%. Meanwhile the Bank believes consumer price inflation is likely to gradually fall back to 2.0% by 2015.
The key announcement from today’s releases, however, was clarification on the nature of the highly anticipated ‘forward guidance’ offered by the Bank of England. Mark Carney indicated that the Bank would consider raising the base rate of interest once the headline rate of unemployment falls to 7.0% – a scenario it does not expect to see until beyond its 2016 forecast horizon.
In offering this forward guidance the Bank of England is performing an interesting balancing act. On the one hand, it feels that providing increased certainty around monetary policy will encourage businesses and individuals to spend and invest within the economy, knowing that the costs of borrowing – and the incentives to save – are not likely to change. On the other hand, providing an unqualified commitment to low interest rates could place the Bank’s credibility in jeopardy.
If the recovery gains momentum and inflation begins to edge up – the latest estimates place inflation on the Consumer Price Index at 2.9% – then the Bank would no doubt wish to raise interest rates. With an unqualified commitment to low interest rates, however, the Bank’s choice would not be as straightforward. Raising rates would mean going back on its own forward guidance and would risk damaging the Bank’s credibility.
To cover itself again such an outcome, the Bank outlined three ‘knockouts’ – scenarios under which the base rate of interest may change regardless of the state of unemployment. Specifically these suggest the Bank may review monetary policy if inflation is expected to be above 2.5% 18 months to two years ahead, if inflation expectations no longer remain ‘sufficiently well’ anchored, or if the financial policy committee (FPC) judge that loose monetary policy poses a threat to financial stability.
Essentially then, what we have here is a compromise between a total commitment to a path of interest rates and a desire to retain some flexibility should economic circumstances change. While this may not be the solid commitment which markets may have hoped for, it does serve to reduce uncertainty by providing further clarification as to the Bank’s thought processes when setting policy – and that is surely to be welcomed.
Consumer Price (CPI) inflation annual change, Bank of England base rate and unemployment rate