Central banks are natural followers of fashion but should avoid becoming a slave to it. That struggle is needed most urgently at the Bank of England.
Mark Carney’s first interest rate decision as bank governor comes today amid stronger data that are unlikely to warrant dramatic immediate monetary easing. So the real impact of the Canadian import will come a month later when the BoE will introduce his big idea: forward guidance. Telling companies, households and markets how long monetary policy will remain ultra-stimulative is all the rage in central banks, including the US Federal Reserve and the Bank of Japan. It is coming to Britain.
The new BoE governor can muster strong arguments for a change. Guidance can ensure that markets know policy will remain loose for longer than the current expectation rates will rise in 2015, providing useful monetary activism and stimulus for a chronically weak economy. Since there are few good reasons why sterling borrowing costs have jumped since the Fed announced its desire to taper quantitative easing, guidance can also help decouple UK gilt yields from those across the Atlantic. And it will enable the BoE to connect with companies and households, which have better things to do than follow the gilts market, by persuading them that borrowing will remain cheap for some time.
To work, such guidance needs to be simple and related to economic objectives of strong growth and low inflation. Danger lies in making policy commitments that may look daft in the future, forcing a central bank to recant and lose face.
The simplest form of guidance is time-contingent, committing the BoE to keep policy ultra-loose for a certain time. Even though Carney is certain this idea saved Canada in 2009, such pre-commitment is risky: the central bank really has little idea today how long it needs to keep its foot on the accelerator. So the BoE will follow the Fed and plump for state-contingent guidance, linking future monetary policy to the development of the economy.
The UK Treasury has asked the BoE to comment on the economic variables it could use as intermediate thresholds, while keeping to its ultimate 2 per cent inflation target. The BoE is likely to use some measure of slack in the economy, connecting a future tightening of policy to the moment spare capacity is judged to have fallen sufficiently as the recovery progresses.
Sadly, measures of UK slack are erratic at the moment. There is no possible way to be polite: all are useless for the task of guidance.
Inflation - the ultimate measure - is forecast to be above the 2 per cent target for the next two years, suggesting no slack, which no sensible person believes. Unemployment is no better as a measure. Its relationship to the rest of the economy has broken down since 2008, so following the Fed’s guidance would involve linking policy to a variable we do not understand. That makes no sense.
The output gap cannot be observed and a range of cyclical indicators, once preferred as markers of slack by the Office for Budget Responsibility, have behaved so strangely that they provide no help either. Since we have no idea whether the pre-crisis trend of output was sustainable, the gap between real or nominal output today and a continuation of pre-crisis trends is also useless.
The lack of a reliable measure of UK slack should not spell the end of Carney’s ambitions. He just needs to go back to first principles and provide some certainty on policy related to the variables that matter for Britain’s economic health.
There is little mystery. The economy has been chronically short of growth in spending on British stuff. I could use the technical term, nominal gross domestic product growth, but the colloquial shorthand is better and easy for households and companies to understand.
Sensible policy should therefore continue with loose monetary policy until spending on UK-produced goods and services has risen to an annual rate of at least 4.5 per cent for two years. An inflation backstop is required to prevent any wage-price spiral, but given the weakness of pay growth, it is highly unlikely to be a constraint. Policy guidance is a good idea, whose time has come. But it must be linked to an economic variable that matters. In the UK, that is spending growth.
Copyright The Financial Times Limited 2013.