Has Bank Of England’s Forward Guidance Backfired?

Published 22 Jan 2014 15:58

LONDON (Alliance News) – The headline rate of UK unemployment is becoming a bit of a headache for the Bank of England.

It dropped to 7.1% in the three months to November 2013, down sharply from the previous reading of 7.4%, according to the latest data from UK National Statistics.

The surprise improvement in employment sent the pound racing higher against other major currencies Wednesday, while UK stocks fell.

UK unemployment took on increased significance in the data calendar back in August 2013 when Bank of England Governor Mark Carney directly linked falling employment to consideration of higher UK interest rates – guiding that the central bank’s base rate won’t rise from the current low of 0.5% before unemployment reaches 7%. At the time, the bank forecast this rate to be reached by mid-2016.

Since the introduction of forward guidance, the UK has had an impressive run of economic performance, with the majority of indicators beating expectations – including unemployment, which has dropped faster than almost anyone expected, from 7.8% to 7.1% – within touching distance of the level cited by Carney.

As the time-line of various independent forecasts for both 7% unemployment being reached, and the UK seeing its first interest rate rise gets shorter and shorter, Carney has been trying to steer markets away from looking the 7% threshold as a target.

In the minutes of the latest Monetary Policy Committee meeting, released at the same time as the latest unemployment numbers on Wednesday, there is acknowledgement that “it was now likely that the unemployment rate would reach the 7% threshold materially earlier than previously expected”, but also that “members therefore saw no immediate need to raise the Bank Rate even if the 7% unemployment threshold were to be reached in the near future”.

The central bank governor has said previously that the 7% level is not a trigger and that rates could stay low after that level has been reached. However, with unemployment knocking on the door of 7%, that approach effectively makes forward guidance redundant. Therefore pressure is building for further action to be taken.

“The issue for the Bank of England is that its forward guidance policy is now outdated after just five months. Mark Carney and co. must decide if they cut the unemployment threshold to 6.5% or 6%, or base future interest rate decisions on wage growth rather than solely unemployment,” said UFX Markets Managing Director Dennis de Jong.

Analysis of the unemployment number suggests that if Carney holds his nerve there may be no need to take evasive action just yet.

CMC Markets Chief Analyst Michael Hewson points out that the headline rate published on Wednesday of 7.1% is a three-month rolling average to November 2013, including the one-month rates of 7.1% in September, 7.0% in October and 7.4% in November. The one-month rate in August, which dropped out of the latest rolling average, was 8.0%, explaining the sharp drop.

On a month-on-month basis, unemployment has actually risen between October and November. Therefore, even if unemployment in December remained stable, there is a good chance of seeing the three-month rolling average headline rate increase at the next print.

The headache for Carney remains that the markets are pricing in an interest rate rise. Since forward guidance was originally announced, the pound has been on an almost inexorable rise, up 10% against the dollar and 5% against the euro. The pound currently is at a 12-month high against the euro and a 6-week high against the dollar.

Mindful Money Economist Shaun Richards calculates this rise to be equivalent to a 1.6% increase in base interest rates. “So we have an external monetary brake being applied on the UK economy rather than an internal one”, explains Richards. The economist therefore argues that the BOE’s forward guidance has actually turned out to be a form of monetary tightening so far.

Earlier in the week, the International Monetary Fund increased its 2014 growth forecast for the UK to 2.4%, from 1.8% previously – a bigger increase than for any other country. The upgrade came with a warning, however: “With prospects improving, it will be critical to avoid a premature withdrawal of monetary policy accommodation, as output gaps are still large while inflation is low and fiscal consolidation continues.”

The mandate of the Monetary Policy Committee is to use interest rates to create price stability and meet inflation targets. With inflation on the way down – having recently fallen to the government-set target of 2.0% – and monetary conditions being tightened by the foreign exchange markets, economist Richards argues that, far from a rise in interest rates, the consequences of forward guidance are creating an argument for a further cut.

All eyes will be on the Bank of England at the next interest rate meeting on February 6, and the release of its next Inflation Report on February 15, to see if Carney makes any change to the forward guidance measures. The BOE governor also is giving a speech in Scotland on Wednesday next week, his first official visit to the country.

By Jon Darby; jondarby@alliancenews.com; @jondarby100