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August 21, 2013 5:33 pm
This month’s announcement that the Bank of England’s Monetary Policy Committee was introducing explicit forward guidance drew considerable interest. But the disappointment that followed – visible in the markets – was based, I believe, on a misinterpretation of recent history and a misreading of the potential for the central bank to change what it does.
Yes, Britain has a new central bank governor and, in Mark Carney, one with a stellar reputation. But the BoE does not have much room to do much different. The real battle over monetary policy was fought and resolved before the Budget in late March; everything since has been mopping up.
Earlier this year there were rumours that there might be a significant change in the MPC’s remit. At the most extreme, there was the suggestion that the inflation target might be replaced by a target for nominal gross domestic product. But, on Budget day, the chancellor published, as usual, his annual letter to the governor defining the MPC’s task. The key statement was: “I confirm that the operational target for monetary policy remains an inflation rate of 2 per cent.”
Not only did George Osborne’s letter not change the target – it did not change the weaponry either. The MPC was not permitted to do anything it was not able to do before the letter was sent, nor was it required to do anything it was not required to do before. So no change there.
The MPC was asked to be more explicit about how it saw and judged the trade-offs inherent in setting monetary policy. This was a reasonable request. In retrospect, but only in retrospect, it would have been better if the MPC had made clearer at an early stage that it was prepared, in the exceptional circumstances of the Great Recession, to allow an extended period of above-target inflation in response to a succession of temporary shocks to the price level.
The MPC’s response to the chancellor’s Budget letter was reported in the minutes of its April meeting. It said: “In responding to this trade-off [between output growth and inflation], the committee was setting policy in broadly the same way that it had done since its formation.” Given the high inflation rate at the time, I thought that was the closest the MPC had come in its history to making a joke.
The chancellor did ask the MPC to report on the possible use of what he called “new unconventional policy instruments”, including forward guidance. But the MPC did not require his permission to deploy these instruments and the Budget letter did not imply that it did. Again, no change. Nonetheless, we waited for the MPC’s response. It always seemed highly unlikely that any change in policy would involve a deliberate relaxation of monetary conditions, including an extension of quantitative easing, since six members of the MPC had voted persistently against it and economic prospects had improved.
And so the August minutes report that, in its discussions before the meeting, the MPC agreed that framing forward guidance in terms of economic developments was likely to be more effective than specifying the period over which it intended to maintain the current stance of monetary policy. The BoE’s report, Monetary Policy Trade-offs and Forward Guidance, sets out the arguments at greater length and provides a convincing case. If the MPC hoped for an immediate effect on interest rates, it will have been disappointed.
Specifying the period might have been more effective in changing market expectations about interest rates, since financial markets do not wholly accept the MPC’s view about the future path of unemployment. They may also be more pessimistic about the path for inflation. But the MPC is, presumably, more concerned to avoid an unwarranted rise in market interest rates later.
In listening to his press conference, I lost track of the times Mr Carney repeated that the MPC’s primary objective was the control of inflation (partly because I was also trying to count the number of times he said that passing the unemployment threshold would not trigger a rise in interest rates but only a consideration of whether such a rise might become necessary). The MPC has crafted an interesting experiment – but all within an unchanged remit.
The writer is a former member of the Monetary Policy Committee
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