28 January 2016
The Blind leading the Blind
What is the point of forward guidance?
by Frank O’Nomics
When should we expect UK interest rates to rise? For many years economist have examined the fan charts of inflation forecasts in the Bank of England Inflation Report for clues as to the likely timing of a rate move. From 2013 that process was helped when, like many other central banks, the BoE adopted a policy of forward guidance. Last week Mark Carney, the Governor of the Bank of England, at this year’s Peston Lecture, included a section in his speech that covered the outlook for monetary policy and what was pretty clear to all is that he does not see UK interest rates rising at any time soon.
All well and good you might argue, and entirely consistent with the Bank’s policy of forward guidance. However, there are many that would disagree, given that just last summer the Bank had been pointing to a rise in rates relatively soon and, as recently as the start of this year, George Osborne (admittedly not someone who has any say in rate moves) was pointing to the recent rate rise in the US as something that the UK should be prepared for. This is important as the earlier forward guidance will have encouraged many to adjust their investment decisions accordingly – decisions which will now look somewhat over cautious, and potentially expensive. Anyone who has locked in a longer-term fixed rate mortgage on concerns that rates were about to rise, will now be burdened with a higher rate for a much longer period than they needed.
A lot seems to have changed in terms of the global and domestic economic outlook since the Bank started to warm up rate rise expectations last year. We will always be vulnerable to unforeseen circumstances, and we are living in a much more uncertain world than that described by Mervyn King in the last decade, as the “nice” era (non-inflationary consistently expansionary). Having encouraged us now not to expect a rate rise until, at the earliest, very late this year, what happens if the oil price bounces significantly and/or sterling falls precipitously (on Brexit fears perhaps) thereby suddenly rejuvenating inflation expectations? Given this backdrop would it not be better for the authorities to be much more circumspect in its forward guidance or maybe just drop it all together?
The Bank of England first incorporated forward guidance into the toolkit designed to help it hit its 2% inflation target in August 2013. It stated that that it was also “designed to help people understand how the MPC sets interest rates” so that “households and businesses can plan their investment with more confidence” . The original forward guidance stated that rates would remain at 0.5% at least until the unemployment rate fell below 7%. At the time unemployment stood at 7.7%, but this has fallen steadily to 5.1%, and still has a downward trajectory. The MPC did include the phrase “provided there weren’t risks to inflation or financial stability” and there is no doubt that at present such risks are considerable. In his speech last week Governor Carney cited the on-going collapse in oil prices, volatility in China and a moderation in domestic growth and wages as reasons why there was little justification in tightening monetary policy. There seems little to argue with here and most market participants will not have been surprised by the contents of the speech, given that they are painfully aware of the asset price falls that have been occasioned by these factors (even with a rally late last week FTSE is still down over 7% year-to-date). But while events will have prepared us for such a speech this will be little consolation to those who have responded to earlier speeches.
As recently as last summer Mr Carney said that the decision to raise rates would come into sharper relief at the start of the turn of the year, and late in October he warned that while a rate rise was a “ a possibility not a certainty” he urged UK households to prepare for tighter monetary policy. For many this may have been sufficient to convey the right degree of uncertainty, but it led some to decide that they did not want to take the risk and hence move their mortgage to a fixed rate. What is the difference? Well, one would have to pay around ½-1% more to have a mortgage at a fixed rate for 5 years, rather than for 2 years – so between £1000-£2000 per annum for a £200,000 mortgage. Not an insignificant decision for most people. Further, for businesses, this may have been sufficient to discourage investment in plant and machinery on the basis that the prospective returns would be reduced by higher borrowing costs.
Part of the problem seems to be, as external MPC member Kristin Forbes acknowledged this week, that the Bank’s forecasting models have not been working very well, and the MPC will need confidence in them before deciding to raise rates. Ms Forbes agrees that a rate rise cannot be justified yet, although she points out that an increase in wage growth momentum, and the loss of the benefits of cheaper energy and a strong currency could quickly change the outlook.
What are the alternatives going forward? The simple answer is that forward guidance is generally regarded as a good thing, and that any additional elements of clarity and transparency regarding the interest rate setting process should be of benefit to the markets and households alike. The question then is one of degree. On the one hand it seems prudent for the Bank to discourage excessive indebtedness and hence be prepared for higher mortgage or loan repayments. On the other, creating too much concern may hinder economic growth by discouraging business investment and leaving households saddled with higher interest charges. From this perspective overly cautious forward guidance could be counterproductive in the process of moving towards the 2% inflation target.
The Bank for International Settlements (the so-called bank of central banks) has in the past warned that forward guidance risks a further financial shock if it entails keeping rates too low for too long. For many it may just not be acceptable to have an MPC that just says we cannot be sure from one month to the next just what the outlook changes will be, and so ensures that forward guidance has so many riders that it ceases to be of any worthwhile substance. While the committee’s decisions have to be put in context, there clearly is a need to have a degree of expectation factored in, but it is also important for them to approach each meeting with an open mind to consider what has changed since they last met, and to react without being restricted by previous forward guidance. As Keynes once said, “when the facts change I change my mind. What do you do, sir?”
