Q&A: What is 'forward guidance'?
The new governor of the Bank of England, Mark Carney, has set out a "forward guidance" strategy to accompany his first inflation report.
Mr Carney faces a UK economy that has been struggling to achieve a sustained recovery - although recent data has been more promising - and which also faces seven more years of government austerity.
With the Treasury unable or unwilling to fulfil its usual fiscal role in supporting the economy - via spending - the pressure remains on the monetary authorities to do more.
"Forward guidance" is a tool that Mr Carney has shown a penchant for in his previous job heading Canada's central bank, and that he more-or-less put into immediate action in a statement following the first policy meeting under his stewardship.
Now he, and the Bank's Monetary Policy Committee (MPC), have delivered explicit guidance regarding the future conduct of monetary policy.
So what has the governor said?
He said that the Bank would not consider raising interest rates until the unemployment rate has fallen to 7% or below.
However, that link could be put aside if the inflation rate threatens to rise above 2.5% in the medium term.
The statement also says that the MPC is also ready to undertake further asset purchases, through the programme of quantitative easing - while the unemployment rate remains above 7% "if it judges that additional monetary stimulus is warranted".
The Chancellor, George Osborne, had asked the Bank to produce a report in time for this August's inflation report.
Forward guidance is not just a strategy being used in the UK. The US Federal Reserve has been increasingly using forward guidance ever since 2008, and now the European Central Bank is also getting in on the act.
What is forward guidance?
It is making a promise about the future, particularly about future interest rates.
The Bank of England, like other central banks, directly controls the short-term interest rate at which it lends to or borrows from the High Street banks overnight.
This is the interest rate that gets set at each of the Bank of England's monthly Monetary Policy Committee meetings.
The Bank has now told the market that it intends to keep this rate at its current historically low 0.5% at least until the unemployment rate falls to 7% or below.
Mr Carney has not said that interest rates will automatically rise when that threshold is reached, rather that it is a "waystation" for further consideration of the issue.
What's the point of forward guidance?
The Bank can only directly control the short-term interest rate. But this rate has already been cut to the lowest level that the Bank feels comfortable with.
Given that it has exhausted the more traditional option of short-term interest rate cuts, another way for the Bank to support the economy has been to offer this indicator, by which companies and mortgage borrowers can estimate for how long such low interest rates may be around for in terms of months or years.
Forward guidance is thus a way of converting low short-term interest rates into lower long-term interest rates.
The thinking is that if the High Street banks can be convinced that they will be able to borrow overnight from the Bank of England at just 0.5% for many nights - indeed many months or years - to come, then they will hopefully be willing to lend money out to the rest of us for the longer term at a commensurately lower interest rate as well.
Isn't that what Quantitative Easing is supposed to be for?
QE also seeks to reduce longer-term borrowing costs, but in a different way.
QE involves the Bank buying up debts (specifically, UK government debt in the form of gilts) from the market, in return for newly created money in the form of a deposit at the Bank.
By reducing the available supply of long-term debts for them to invest their money in, the hope is that this will make banks and other financial institutions diversify into other long-term investments - including new loans to the rest of us.
Or, to put it another way, by reducing the supply of long-term debt in the financial system, the Bank hopes to drive up the value of the remaining long-term debts, which is mechanically the same thing as driving down the "yield" or interest rate on such long-term debts.
Then why not just rely on QE?
There is no either/or here. The Bank of England can restart its QE purchases if it wants, while also providing forward guidance about its interest rate and QE plans.
However, recent market jitters over plans by the Federal Reserve (the Bank's US counterpart) to "taper" or slow down the rate of its own QE purchases has highlighted two problems with QE:
- Firstly, it has played on fears, expressed by many bankers, that QE merely inflates bubbles in the prices of other investments, such as risky loans and share prices, which will then burst as soon as the QE stimulus is withdrawn
- Secondly, the surprisingly strong reaction of markets to the change in tone from the Federal Reserve highlights how important market expectations- as opposed to the mechanics of supply and demand - are for the effectiveness of QE
In its "forward guidance", the MPC has said it stands ready to undertake further asset purchases while the unemployment rate remains above 7% "if it judges that additional monetary stimulus is warranted".
What conditions, if any, has the Bank put on its guidance?
The Bank has said that its guidance linking interest rates and asset sales to the unemployment figure would cease to hold if any of the following three "knockouts" were breached:
- in the MPC's view, it is more likely than not, that CPI inflation 18 to 24 months ahead will be 0.5 percentage points or more above the Bank's 2% target
- medium-term inflation expectations "no longer remain sufficiently well anchored"
- the Financial Policy Committee (FPC) - which monitors potential systemic risks - judges that the stance of monetary policy "poses a significant threat to financial stability that cannot be contained by the substantial range of mitigating policy actions available to the FPC, the Financial Conduct Authority and the Prudential Regulation Authority in a way consistent with their objectives".
Is the Bank tying its own hands?
Unfortunately, the Bank cannot actually do that.
Whatever promises it may make now, it will always have the right to change its mind later. Indeed, Mr Carney did exactly this in his time at the Canadian central bank, breaking an earlier promise not to raise interest rates for at least a year.
This inability to tie its own hands presents the Bank with a conundrum - how to convince markets today to believe promises that in the future it may be strongly tempted to renege upon.
Then how can the Bank get anyone to believe it?
It seems to come down to a question of tone.
The recent frighteners given to the market by the Fed's "tapering" announcement provide a case in point.
All the Fed actually did was offer a tentative timetable for when it expects to wind down its purchases - in other words, forward guidance for QE.
But the market reaction was to price in a strong possibility that the Fed will raise interest rates next year, even though the Fed made very clear that it did not intend to raise interest rates before 2015.
The market apparently drew the inference that the Fed was getting cold feet about QE, and hence no longer took the Fed at its word.