Infinite improbability

Members of the Monetary Policy Committee (MPC), led by Bank of England Governor, Mark Carney, mounted a very obvious rear-guard action after the publication of the latest Inflation Report, trying to justify their reworked view of the economy and also their previous forward guidance. On both fronts, markets and commentators were sceptical. In itself, this was noteworthy, since financial markets have a natural predisposition to trust central bankers. Why, is not clear, since the faith placed in our policy makers to get it right has been massively disappointed in recent years. Heralded by a fanfare from the Treasury, Mr Carney was given the keys to the front door of the Bank on the 1st July 2013, and it was but a few moments later that he announced the new policy style of forward guidance. At the time, this felt rushed. Had Mr Carney really had enough time to get to grips with the UK economy and policy environment before he announced his big plan for the future of UK policy-making?

Moving the story on another few months, and we can answer this question very simply – ‘no’. Mr Carney’s forward guidance was based on a 7% threshold for unemployment. While some Bank officials are now trying to reinterpret the implicit message that was fed to markets, it seemed pretty clear at the time that the Governor was saying that once the unemployment rate had fallen below 7%, it was likely that monetary policy would be tightened. Immediately, the MPC was a hostage to fortune. To make the future course of policy so dependent on a single number could only be appropriate if the Bank’s economists had a decent idea of how conditions in the labour market were likely to evolve. Given the Bank’s horrible track record when forecasting inflation and GDP, we should have been prepared for another gaff. The fact is that employment has risen and the unemployment rate has fallen substantially more rapidly than Mr Carney and team envisaged.

In fact, what Mr Carney really wanted to say last August was that, come what may, he (‘he’ because it is not clear that he was speaking with the full support of everyone on the MPC) had no intention of raising interest rates for the foreseeable future. But to have phrased his guidance in this fashion would have spooked financial markets – quite rightly. So he established the guidance in the context of an unemployment threshold that he presumed would give him ample room for manoeuvre. Wrong.

So, how should we interpret the latest batch of forecasts? Mr Carney and team now believe that the unemployment rate can fall to between 6% and 6.5% without stresses becoming apparent in the labour market. Furthermore, the Bank’s assessment is that there is between 1% and 1.5% of spare output capacity. As for the wider economy, the MPC is predicting that if interest rates are left unchanged this year, GDP will increase 3.75%. The only way that these numbers can be reconciled is via an astonishing – and, on the basis of recent trends, improbable – surge in productivity. Indeed, coming up with a coherent explanation of the MPC’s medium-term forecasts is quite difficult.

It is self evident that Policy makers in the UK and elsewhere in the West still regard the greater risk as being a premature tightening in policy. My assessment is that we may be approaching the point at which the risk swings around – that a belated tightening in policy results in a significant deterioration in the outlook for inflation.

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