At its meeting on 1 August 2013, the Monetary Policy Committee (MPC) agreed to provide state-contingent forward guidance concerning the future conduct of monetary policy. The aim was to provide more information to help financial markets, households and businesses understand the conditions under which the current stance of monetary policy would be maintained. In essence, the MPC judged that it would be appropriate to maintain the current exceptionally stimulative monetary stance until the margin of slack within the economy had narrowed significantly, provided that such an approach remained consistent with its primary objective of price stability and did not endanger financial stability.
In particular, the MPC outlined its intention neither to raise Bank Rate from its current level of 0.5% nor reduce the stock of asset purchases financed by the issuance of central bank reserves at least until the unemployment rate has fallen to a threshold of 7%.
The guidance linking Bank Rate and asset sales to the unemployment threshold would cease to hold if any of the following three 'knockouts' were breached:1
- In the MPC’s view, it is more likely than not, that CPI inflation 18-24 months ahead will be 0.5pp or more above its 2% target.
- Medium-term inflation expectations no longer remain sufficiently well anchored.
- The Financial Policy Committee (FPC) judges that the stance of monetary policy poses a significant threat to financial stability that cannot be contained by regulatory actions.
As noted by Bean (2013), the primary aim of the MPC’s forward guidance is to clarify its reaction function and thus make its current policy setting more effective. It is not an attempt to inject additional stimulus by pre-committing to a ‘lower for longer’ policy with the aim of pushing inflation above target for a period; raising inflation expectations and reducing real interest rates, such as that described by Woodford (2012). That is for two reasons. First, UK inflation has been above, rather than below, its 2% target for much of the period since 2007. Second, even if such a strategy were to be successful in boosting economic growth, there is no mechanism by which existing MPC members can pre-commit future Committee members to such a strategy.
The MPC believes its forward guidance should enhance the effectiveness of monetary stimulus in three ways. First, it provides greater clarity about the MPC’s view of the appropriate trade-off between the horizon over which inflation is returned to the target and the speed with which output and employment recover. Second, it reduces uncertainty about the future path of monetary policy as the economy recovers. And third, it better enables the MPC to explore the scope for economic expansion without putting price and financial stability at risk.
What are the challenges facing the UK economy?
The MPC’s adoption of explicit forward guidance was motivated by the exceptional challenges facing the UK economy. Over the past six years, the UK economy has faced substantial demand and supply shocks. As a consequence, UK output growth has been weak compared with both previous recoveries and current recoveries in other countries (Figure 1): in 2013 Q2, UK real GDP was still more than 3% below its pre-crisis peak. The unemployment rate, at just a little below 8%, is around three percentage points higher than its average in the decade before the crisis.
This anaemic recovery has been accompanied by significant uncertainty regarding the evolution of the supply capacity of the UK economy. A period of weak output growth would normally be expected to result in a large margin of spare capacity. But business surveys suggest that spare capacity within companies has actually narrowed since 2009 (Figure 2), labour productivity has fallen back to 2005 levels, and domestic inflationary pressure has been stronger than expected. All of these factors are suggestive of a substantial weakening in supply capacity. But it is unclear how much of this weakness is directly related to demand and how much reflects other factors, such as problems in the banking sector. Consequently, a key uncertainty faced by the MPC currently is how productivity and supply will evolve as demand recovers.
Figure 1. Evolution of GDP around recessions(a) and banking crises
Sources: OECD, Reinhart, C.M and Rogoff, K.S (2008), Thomson Reuters Datastream and Bank calculations.
(a) Defined as at least two consecutive quarters of falling output.
(b) Where data are available, covers the G20 advanced economies over the period from 1960 to 2006.
(c) Spain (1977), Norway (1987) Finland (1991), Sweden (1991) and Japan (1992), as defined in Reinhart, C.M and Rogoff, K.S (2008) ‘This time is different. Eight centuries of financial folly’.
(d) Zero denotes the pre-recession peak in GDP, or the peak in GDP during the year of the banking crisis, as listed in footnote (c).
Figure 2. Survey indicators of capacity utilisation(a)
Sources: Bank of England, BCC, CBI, CBI/PwC and ONS.
(a) Three measures are produced by weighting together surveys from the Bank’s Agents (manufacturing and services), the BCC (non-services and services) and the CBI (manufacturing, financial services, business/consumer services and distributive trades) using nominal shares in value added. The BCC data are non seasonally adjusted.
How does forward guidance help in these circumstances?
The MPC’s primary objective, as set by the Government, is to deliver price stability. The MPC’s remit also recognises that, when faced with adverse supply shocks, the Committee should vary the pace at which inflation is returned to the target so as to avoid generating undue volatility in output.
At the current juncture, with both inflation and economic activity far from desirable levels, explicit forward guidance can provide greater clarity about the MPC’s view of the appropriate trade-off between the horizon over which inflation is returned to the target and the support provided to output and employment. That greater clarity should help individuals to make better-informed expectations about future interest rates, which in turn influence households’ and businesses’ spending and saving decisions.
Moreover, as the UK recovery begins to gain traction, providing explicit guidance about the future path of monetary policy might be especially useful. In particular, there is a risk that households, businesses and financial market participants overreact to signs of a recovery, either in the UK, or in other countries where the economic recovery is more advanced. This might cause people to revise up excessively their expectations of the future path of Bank Rate, causing monetary conditions to tighten and so hindering the emerging recovery. By tying its guidance to the unemployment rate, the MPC has made clear that, even if a period of robust GDP growth appears likely, interest rates would be raised only if that were accompanied by a substantial decline in spare capacity in the labour market (subject to there being no material risks to either price or financial stability).
The scale of recent shocks, and the difficulty in knowing how effective supply will respond as demand picks up, means that the trade-off between the speed with which inflation is returned to the target and the scope for economic expansion is unusually uncertain. Attempting to return inflation to the target too quickly risks prolonging the period over which the nation’s resources are underutilised, which, in turn, might also erode the medium-term supply capacity of the UK economy. But returning inflation to the target too slowly might cause people to question the MPC’s commitment to keep inflation close to the target. Such a loss of credibility would make it more costly to keep inflation close to the target. Either outcome would lead to significant economic costs in the medium term.
In that context, forward guidance provides a robust framework within which the MPC can explore the scope for economic expansion without putting either price stability or financial stability at risk. If productivity were to recover more quickly than anticipated, unemployment would fall less rapidly, resulting in weaker inflationary pressure. In such circumstances, the MPC’s guidance implies that the accommodative stance of policy would be maintained for a longer time period. But if unemployment fell more rapidly and inflationary pressures began to emerge, the MPC’s guidance – including the price stability knockouts – would point to a faster withdrawal of policy stimulus.
What design considerations were important for the UK?
Given the uncertainty surrounding the evolution of supply, the MPC judged that the unemployment rate was the most suitable indicator of economic activity to guide its policy. In particular, it seems likely that, as demand recovers, some of the spare capacity within companies will decline before, or at the same time as, the unemployment rate falls and slack within the labour market narrows. As such, by linking the path of Bank Rate to the evolution of unemployment, the MPC can set policy in order to reduce the degree of spare capacity in the economy, even if there is considerable uncertainty over the extent to which productivity will pick up as the recovery gathers pace.2
The MPC have set the unemployment rate ‘threshold’ at 7%: lower than the current unemployment rate of 7.7%, but somewhat higher than Bank of England estimates of the medium-term equilibrium rate (6.5%).3 7% is not a target for unemployment, nor is it a trigger for immediate monetary action (indeed, it is likely that unemployment will eventually fall below that level). Instead, as noted by Carney (2013), it represents an appropriate point at which the MPC will reassess the state of the economy – taking account of a wide range of measures of economic slack and inflationary pressures – and consider whether or not it should start to withdraw the current extraordinary levels of monetary stimulus.
Price stability remains the MPC’s primary objective, and its policy guidance is conditional on two price-stability 'knockouts': one defined in terms of the MPC’s inflation forecast and one in terms of external measures of inflation expectations.
CPI inflation is close to 3% and is expected to remain so for much of the rest of this year. By setting its inflation forecast knockout at 2.5% or more at the 18- to 24-month horizon, the MPC sought to strike an appropriate balance between not bringing inflation back to the target so quickly as to threaten the recovery, and not bringing it back so slowly as to cause people to question its determination to hit the 2% target over the medium term.
When assessing the inflation expectations knockout, the MPC will consider: the level of inflation expectations; movements in uncertainty about future inflation; and the sensitivity of inflation expectations to economic news.
The MPC’s remit also recognises that attempts to keep inflation at the target could generate risks to future financial stability. The Financial Services Act 2012 established an independent Financial Policy Committee (FPC) at the Bank of England charged with identifying, monitoring and taking action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system. One of the tasks of the FPC will be to alert the MPC publicly if 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 UK regulatory authorities. That is because financial instability could have lasting effects on the economy, damaging growth and endangering price stability. In such circumstances, monetary policy may have an important role to play as a last line of defence in mitigating risks to financial stability.
Bean, C (2013), "Global aspects of unconventional monetary policies", Federal Reserve Bank of Kansas City Symposium, Jackson Hole.
Carney, M (2013), "Crossing the threshold to recovery", Speech at a business lunch hosted by the CBI East Midlands, Derbyshire and Nottinghamshire Chamber of Commerce and the Institute of Directors.
Financial Policy Committee (2013), ‘The Financial Policy Committee’s powers to supplement capital requirements: a draft policy statement’.
Monetary Policy Committee (2013), "Monetary policy trade-offs and forward guidance".
Woodford, M (2012), ‘Methods of policy accommodation at the interest-rate lower bound’, Federal Reserve Bank of Kansas City Symposium, Jackson Hole.
1 See Monetary Policy Committee (2013) for more details.
2 Moreover, unemployment data are timely; not subject to substantial revision; and are well understood by both financial market participants and the general public.
3 See page 28-29 of the August 2013 Inflation Report for further details.