The Monetary Policy Committee's search for guidance

 

The slightly better-than-expected inflation figure for June continues the run of good news for Mark Carney. Of course, it would be better if inflation were going down, not up. But it could have been worse.

It leaves the way clear for him to focus on his most pressing task: coming up with a way to make "forward guidance" part of the Monetary Policy Committee's tool-kit for supporting the economy.

That is indeed a big job, which some in the Bank do not feel they have been given much time to complete. George Osborne wants a decision in time for the next Inflation Report press conference on 7 August, which realistically means that the new approach will need to be there to inform the monetary policy decision the previous week, on 1 August.

At bottom, there are really two questions that the chancellor asked the MPC to answer.

First, would it be helpful to the UK economy for the Bank to offer more "forward guidance" on monetary policy?

Second, following on from that, should that guidance include an "intermediate threshold" - a staging point that the real economy needs to meet for policy to change - and if so, what should that threshold be?

You'll be relieved to hear I'm only going to talk about the first question here. I'll think you'll find that's more than enough to be getting on with.

The most often-talked about model for forward guidance is the one developed by the economist Michael Woodford, which I've talked about before.

Very briefly, that says that in the deflationary environment following a financial crisis, the central bank might be able to bring forward what might otherwise be a very slow economic recovery, by persuading the markets that it is willing to keep interest rates lower - and let inflation go higher - than its usual approach would suggest. (You can read the spoddy version here.)

If individuals and companies internalise this advice - and borrow and spend in the expectation of that recovery - the model says the growth will actually come sooner than it would have done, and the central bank might even be able to limit the overshoot in inflation, in practice, by going back on its promise. Win-win. All that matters is that everyone believes the guidance when it's offered.

So far, so interesting. The problem - as I've mentioned before - is that it's just not very relevant to the UK. The risk of falling prices in the UK right now is more or less non-existent. Everyone already expects inflation to overshoot - the only question is how far and how long.

But, you'll be thrilled to hear, there are other ways of thinking about guidance, now being vigorously debated inside the Bank, which are more relevant to the UK - and, for that matter, the ECB.

The first is simply as a way of correcting investors when they have got things wrong. If the expected path of monetary policy built into market interest rates is inconsistent with what the Bank's own policy framework would suggest, you say that.

That is the kind of guidance we had from the MPC earlier this month, and you might say it was entirely consistent with policy under Sir Mervyn King. In fact, Sir Mervyn told the Treasury Select Committee more or less the same thing, in his last appearance there, just a few days before Mark Carney arrived.

Observing that the markets have got it wrong is not inconsequential, especially when interest rates have moved as far as they have in response to Ben Bernanke's comments in May. But it can only get you so far.

You can imagine the MPC going a step further down this road next month, to say that not only are rates "inconsistent" with economic fundamentals, but flat-out wrong.

You could also imagine the MPC using guidance to materially change everyone's expectation of when the first rate change will be. That should cut short- to medium-term rates as well - meaning cheaper borrowing costs, hopefully, for companies and households. But I suspect that many on the MPC would consider this step a loosening of the target, given that the economic environment has not really changed.

However, in his past speeches on this subject, Mark Carney has spoken of another way that guidance can "correct" market rates - even when people already have an accurate view of the Bank's expectations.

This comes from a curious feature of life when the official policy rate has gone as low as it can go. Namely, that "interest rate risk is asymmetric: short-term rates can rise, but they cannot fall. This asymmetry causes the mean or expected outlook for short rates to be greater than the mode or most likely path."

In other words, even if most people expect rates to stay at 0.5% for three years, market rates will end up higher than that central expectation - if there's any uncertainty about it at all - because that uncertainty can only go one way: we know for sure that rates cannot go down.

That, in turn, means long-term rates get pushed up and credit conditions are tighter than market expectations of future policy would lead you to expect.

Guidance can correct this, Mark Carney argues, by getting rid of some of that uncertainty about rate rises. Even if the guidance is exactly in line with what the markets thought before. Tah-da.

By now, you probably think you know all you ever wanted to know about the technical arguments for policy guidance by the MPC. (If you haven't stopped reading hours ago.) But let me throw in one other way of looking at it - which I'll call "transparency with a purpose".

Stanley Fischer, the distinguished economist and former head of the Israeli central bank, had some wise words for me on this subject: he said policymakers will get themselves into trouble if they think they can use guidance as a way of "tricking" the markets into a combination of inflation and growth that would otherwise not be on offer. In his view, the only sensible way to think about guidance is as an extra dose of central bank transparency.

You might think central bankers should always be as transparent as possible about everything that could affect their future decisions. But that's not really true.

After all, they have their credibility to consider. Also their flexibility. Arguably, transparency can be bad for both - especially if it publicly ties itself to a particular way of looking at the world which it later finds it would like to reverse.

If there is a spectrum of views on the right balance between transparency and flexibility, for central banks, it is fair to say that Sir Mervyn was on the side of flexibility. He did not think it was helpful for the Bank to admit publicly that it had changed its mind.

And he did not think it was helpful for the Bank to "tie its hands" in advance. With him, it was: "We take every meeting as it comes."

Mark Carney clearly takes a different view. In the speech I referred to earlier, he says, in effect, that today's post-crisis circumstances might well tip the balance in favour of more transparency.

In this environment, he suggests, the central bank might well find it is more effective if it tells the markets and the public more than it would usually want to tell them - not just about the level of inflation it is willing to tolerate, but also about the real economic outcomes it will be looking for when it sets policy in the future.

That's not transparency for transparency's sake: it's transparency with the express purpose of helping the domestic economy, in a situation in which the central bank's normal tools for guiding the economy are seriously impaired.

As we know, there's still a lot of uncertainty about what's going on in the real economy, and how fast the UK can actually grow before domestic wages and price pressures pick up. (See all my previous stuff on the "productivity puzzle" and other delights.)

This way of looking at guidance would have the Bank saying how it plans to live with that uncertainty: how it will be monitoring the capacity of the economy going forward, and how it plans to adjust policy in line with those observations.

Depending on how it was framed, the message would be: "We're going to err on the side of expecting too much of the economy, rather than too little."

I don't get the impression that most MPC members would be hugely opposed to the "transparency" kind of guidance. Whether a majority thinks it would make a big practical difference is another matter.

Much will depend on how, exactly, the MPC spells out its intentions, and the economic yardsticks it says it will use along the way. What those yardsticks might be, I will write about (phew) in a later post.

 
Stephanie Flanders, Economics editor Article written by Stephanie Flanders Stephanie Flanders Former economics editor

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  • rate this
    0

    Comment number 41.

    32NaYmE
    Thus "forward guidance" is yet more hot air!
    ~
    As I was, effectively, pointing out by dismantling Steffie's piece at #11-14.

    I think we are in dangerous territory economically. Govt still spending here & there, no real evidence of clear understanding at No11, Treasury or the BoE of 1. how to escape now, 2. the underlying structural problems, & 3. how to set about dealing with them.

  • rate this
    0

    Comment number 40.

    @30 David E
    There are types of inflation that interest rates alone cannot control. That also assumes that Brown's parameters were right in 1997/98 and are right for the UK economy now.

    Please see my earlier posts, incl. #39

  • rate this
    0

    Comment number 39.

    15.J_f_H
    Not true - they are creating a huge inflationary bubble which will go on to cripple the economy for decades. Zero % mortgages!
    ~
    I am afraid it is true. A rate increase would not curb inflation.

    Mortgages, btw, are NOT at 0%. Base rate nearly is, but I doubt anyone, except perhaps the highest earners, can get a loan at Base + 2%.

    G. Brown is the man to blame! :-)

  • rate this
    +2

    Comment number 38.

    The need for "forward guidance" is clear. Even the MPC would agree that there is no benefit in having the base rate at 0.5% rather than 1%. It was cut to 0.5% to "send a message" that the MPC were committed to loose monetary policy. Message received. Now rates cannot be increased without sending a conflicting message. The required guidance is that loose policy will be pursued by other means.

  • rate this
    +3

    Comment number 37.

    The asset prices of shares and houses have been in a bubble for some time.

    Whe interest rates rise the bubble will burst and we will have seen another boom and bust.

    The sooner we raise interest rates and burst the bubble the smaller will be the bust.

    The B of E should get back to its task of keeping inflation at 2%, not tolerating constantly higher rates.

  • rate this
    +1

    Comment number 36.

    #35
    The rewards and virtues of thriftiness & saving were instilled into us at an early age from Gov & Banks
    ISA’s were set up to ecourage just that
    Then gluttony and easy debt became king and it all dissolved into a greed swamp
    The banks even pickpocket the ISAs with stealth IR

  • rate this
    0

    Comment number 35.

    @33 Sonja,
    Not sure there is any rational law that savings have to earn interest. Let alone interest above the rate of inflation.

    If everybody did that - everybody could be a bank. And look where that got us...

  • rate this
    +1

    Comment number 34.

    Stephanie wrote: "As we know, there's still a lot of uncertainty about what's going on in the real economy, and how fast the UK can actually grow before domestic wages and price pressures pick up."

    Price pressures are already real - wage pressures must follow.
    Devaluation, not growth is driving this

  • rate this
    +3

    Comment number 33.

    Steph,
    I’m sure you probably dismiss rants about low interest rates & artificially propped up HP as SAME OLD-SAME OLD but even MOODYS have expressed concern about this in Oz today
    Also as a saver I’m really HACKED OFF that home owners (that I’m propping up with my zilch IR) got 3% TAX FREE HP increase on their homes last month
    All fuelled by this artificial bubble

  • rate this
    +9

    Comment number 32.

    The major economic problem for the UK is the continuing fall in real wages.

    "These continue to fall and the new inflation (CPI) numbers mean that if we adjust wages for them they are now falling at an annual rate of 1.6%. For those who feel that the RPI is more realistic then real wages are falling at an annual rate of 2%."

    http://bit.ly/13uLI8D

    Thus "forward guidance" is yet more hot air!

  • rate this
    +1

    Comment number 31.

    BOE - not been of much benefit last decade.

    Nice old building though. Perhaps, they should start some daily tour business to help with the deficit.

  • rate this
    +2

    Comment number 30.

    The MPC's task is to control inflation at 2% plus or minus 1%.

    If the Government wants more investment growth, then it can change tax rates and other restrictions on companies.

    It should not twist the MPC's arm to tolerate inflation outside the target range. The B of E was given responsibility for setting interest rates to stop such bad political influence.

  • Comment number 29.

    This comment was removed because the moderators found it broke the house rules. Explain.

  • rate this
    +2

    Comment number 28.

    You dont have to be "we're all doomed" like JfH to think that the MPC is a waste of time and all this talk of expectation is just smoke and mirrors. Firms will invest when they experience real growth over a good period but where is that growth coming from when real wages are declining substantially and the government continues to deflate the economy through public expenditure cuts.

  • rate this
    +3

    Comment number 27.

    2.9% - yep try telling that to the majority on 85% of the mean in terms of income (i.e. the median)

    Utter utter fantasy land - as Aqua referenced earlier try 7-8% as the real measure.

  • rate this
    +3

    Comment number 26.

    also lol at your headline SF, the 'search for guidance' sounds v new age doesn't it?
    I can think that in the present situation meditation, yoga, a higher being or just good advice from JfH might win the day.
    Failing that,how about a visit to the mother ship.......

  • rate this
    +2

    Comment number 25.

    'the central bank's normal tools for guiding the economy are seriously impaired'
    forget about yardsticks SF, its a micrometer for growth and a GSM for inflation.
    this is all fudge to keep interest rates artificially and dangerously low because the govt has overextended.
    the only tool left by MK is the shovel to dig the hole

  • rate this
    +1

    Comment number 24.

    Surely this is a best a one-off (and not for particularly long) gain, and therefore not part of a "tool-kit"?

    Once the market makers have some idea of how accurate or otherwise the guidance is, the it becomes just another input into their pricing models, to be accommodated or discounted as appropriate, and so ceases to have any fashionable "nudge" effect - just in time for the next downturn.

  • rate this
    +3

    Comment number 23.

    on bubbles...

    Present UK house price levels are completely unaffordable FOR THE ECONOMY. We have a dead economy and dead capitalism where ONLY zombie companies exist. This is a dead hand crushing the people, jobs, pensions, savings and investment.

    We have to drastically reduce the price of houses (one way or another) or we are bu....ed and will remain so for generations. That is the bubble.

  • rate this
    +3

    Comment number 22.

    20. Kevinharding "Japan the country with the longest and largest QE "

    Yes Kev - remember the way the Japanese got there was to have a policy of zero or negative interest rates.

    I (& others) argue that their 20 year malaise is directly down to the collapse in the price of money.

    They have to force interest rates up to kill zombie businesses (& banks) so that the real capitalist system can grow.

 

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