When your predictions are confounded, do you carry on regardless? Or do you stop, think and consider changing course? Such is the remarkable recovery in the UK economy since the first quarter of last year that the Bank of England is now facing this acute dilemma.
Just five months ago, the bank’s new governor pledged that the BoE would not consider tightening monetary policy until unemployment fell to 7 per cent so long as inflationary pressures remained in check. Adopting the language of celebrities on Strictly Come Dancing, the British television show, Mark Carney repeatedly talked about this forward guidance giving him time to go on a “learning journey”.
The policy was the result of two punts taken by the BoE’s Monetary Policy Committee last August. It bet that there was little danger in keeping interest rates at 0.5 per cent until the 7 per cent threshold was hit, as the seeds of future inflation would not be sown with such high joblessness. It also wagered that the journey to 7 per cent would be long so it could do quite a lot of learning, and the first consideration of a rate rise would most likely be postponed until 2016.
While the first gamble appears to have paid off, the second could not be more wrong. It is now as likely as not that the BoE’s learning journey came to an end before Strictly’s Christmas finale. Such has been the pace of job growth, there is a strong chance that data published next month will show the unemployment rate fell to 7 per cent in the fourth quarter of 2013.
The question is what the BoE should now do. Worst would be to show guidance was entirely a sham by redefining the unemployment threshold, reducing it to 6.5 per cent. Carrying on regardless of the data is no way to run monetary policy. Instead, the BoE should be true to its word and undertake a thorough consideration of a rate rise alongside its quarterly forecasts in its February inflation report.
The BoE correctly insists that the 7 per cent rate is a threshold for consideration of monetary tightening rather than a trigger for action, and that any decisions should be based on the evidence regarding slack in the economy. Unemployment is merely a proxy for the concept of spare capacity, not its definition.
The trouble for the UK is that the evidence for the erosion of slack in the economy is compelling, and MPC members know it. For years the BoE has said we should ignore survey data suggesting little spare capacity in companies because unemployment has been so high. Now joblessness is falling, it cannot change its mind.
Even if the MPC is tempted to switch focus away from unemployment, it cannot point to more convenient survey data because that is also red hot. The British Chambers of Commerce quarterly survey this week showed company recruitment difficulties at almost record levels in manufacturing and services. The scores for capacity utilisation were also way above average, and near record levels. This long-running survey suggests interest rates should not be stuck at 0.5 per cent, but many percentage points higher at above normal levels.
Productivity growth was yet again disappointing in the third quarter of 2013, with output per hour falling, removing another prop from the case for low rates. With that, the standard evidence that the economy has scope to withstand fast growth without inflation is diminishing fast.
Even the fall in the inflation rate from 2.9 per cent in June to 2.1 per cent in November 2013 does not provide much comfort because the BoE has spent the past five years explaining that short-term movements in the inflation rate are influenced by many one-off factors and should be ignored.
Set against these reasons to withdraw stimulus are more fragile arguments with which I still largely agree. Income growth remains low; the recovery is not yet secure; there is probably still sufficient slack to keep inflation down even though the margin has fallen; and a productivity rebound must surely come soon.
For me, the logic begins to point towards a rate rise, but I still favour holding off for a while longer. I would be willing to tolerate a period of higher inflation if my hopes about the degree of slack were baseless.
Mr Carney might well agree. But, after being so wrong about unemployment, he must show that he takes the consideration of rate rises seriously.
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