Clarity Versus Flexibility at the Bank of England
A month after taking charge at the Bank of England, Mark Carney has announced a decisive break with the old way of communicating the central bank's intentions. The new way is "forward guidance," pioneered by Carney at the Bank of Canada and subsequently adopted, with mixed success, by the Federal Reserve and the European Central Bank.
The idea is fine in principle, but, as the Fed and ECB have lately demonstrated, it's tricky to apply in practice. The instant reaction to Carney's announcement suggests as much. He said the central bank's target interest rate would stay very low at least until the U.K.'s rate of unemployment falls to 7 percent, which he said might be in 2016. At this, the pound strengthened and long-term interest rates briefly went up -- in effect, a slight tightening of policy, one that Carney presumably didn't intend.
The logic behind forward guidance is appealing. It starts with a question: How can a central bank ease monetary conditions if short-term interest rates are already at zero? The answer: Promise that rates will stay low, or that unconventional measures such as quantitative easing will stay in place, for longer than financial markets were expecting.
It isn't as easy as it sounds. Everything depends on the clarity and credibility of the bank's promise. With typical thoroughness, the Bank of England today published a detailed paper on the different forms forward guidance might take.
David Fuller's view Mark Carney's first public appearance as Governor of the Bank of England was calm and reassuring. Central bankers now understand that if they remove a monetary stimulus too quickly following a financial crisis, or if they unintentionally contribute to an overly cautious public response, slowly recovering economies can too easily stall. This is why we now have forward guidance.
Basing this guidance mainly on a lower target for unemployment shows diplomatic social awareness but can also risk over stimulating the economy in this environment of accelerating technological innovation. Smart machines are replacing people in the workforce at a faster rate than ever before. While 7% unemployment should be more easily achieved than the US Federal Reserve's target of 6.5%, the eventual cost is likely to be higher inflation when these economies really do recover.