Carney's about-turn steers the BoE forward

FT.com

Mark Carney became governor of the Bank of England on the understanding that he would shake up monetary policy in Britain. The former chief of the Bank of Canada did not disappoint: merely a month into his term, the Monetary Policy Committee had already introduced a policy of “forward guidance”, pledging not to raise interest rates while unemployment remained above 7 per cent.

But six months later, Mr Carney’s revolution has expired. Yesterday the MPC announced it would no longer link the future direction of interest rates to a single indicator. Guidance has survived but in a milder form: the BoE will provide more information about its thinking on interest rates but will not make an exact forecast. For now, the MPC has ruled out any immediate tightening, adding that when rates go up they will follow a “gradual path”.

Mr Carney’s U-turn is an embarrassment for Threadneedle Street. Last August the BoE had forecast that the unemployment rate would stay above 7 per cent until 2016. Yet joblessness has fallen much faster and - at 7.1 per cent - it is only a whisker away from the MPC’s threshold.

Even so, while it is now clear the bank was wrong to tie its destiny to a variable it did not fully understand, very few analysts predicted that the recovery would be as strong as it turned out to be. Nor did this blunder cause much harm to the British economy. In fact, guidance may have done some good, insofar as it prevented market rates from jumping in spite of a flurry of good economic news.

Still, the governor was right to abandon his flagship policy. Lowering the unemployment threshold below 7 per cent would have sent a confusing message to investors, who would have wondered just how credible the new target might be. Swapping one variable with another - say, the growth rate of real wages - would have been just as puzzling.

For now the governor seems to have pulled off a neat trick. There were concerns that market rates could jump at the news that the BoE had abandoned its original formulation of guidance. While yields on the 10-year Gilt went up on the news, they only rose by 5 basis points to 2.79 per cent.

Yet Mr Carney still has important questions to answer. The most relevant is whether the Monetary Policy Committee’s continuing reluctance to raise rates is appropriate. After all, the recovery is picking up pace. The BoE expects growth this year to hit 3.4 per cent, as investment in housing and new equipment catches up with the rise in consumer spending. With house prices also bubbling up, calls for an early tightening are not completely out of place.

For now, the evidence seems to be on Mr Carney’s side. True, one should remain sceptical of the BoE’s own estimates of spare capacity in the economy. These are largely based on evidence from the labour market, an area the MPC has struggled to understand. But prices remain in check: inflation is expected to remain close to the BoE’s 2 per cent target over the next three years.

Furthermore, the bank’s hyper-bullish growth forecasts may well be too optimistic. The government’s austerity programme will continue to weigh on growth and, as sterling keeps appreciating, net exports are unlikely to pick up. Since real wages are still stagnant there is only so much more consumers can do to boost the economy. Were companies to continue hoarding cash rather than investing, growth may well disappoint.

The truth is that we still do not fully understand what is driving the recovery and how strongly the upturn will continue. The lesson for the BoE is to keep an open mind. Mr Carney was right to show flexibility over guidance. He should do the same over the more important question of what will happen to rates.

It is important to ask whether the BoE’s reluctance to raise rates is appropriate.

Copyright The Financial Times Limited 2014