Carney’s cross. The Old Lady of Threadneedle Street has got her knickers in a twist. Though the Bank of England has been known as the Old Lady since the 1790s, she remains attracted to new tricks. The most recent of them, the brainchild of the Bank’s new governor Mark Carney, was meant to increase clarity, but it has only caused confusion. The principal cause of the problem has been the unreliability of economic forecasts and the people who interpret them.
Carney’s policy is known as forward guidance. It is not yet a year old and it is already causing him discomfort. The Bank’s most important single power is setting bank rate, or the rate of interest that forms the basis for monetary policy. This task is performed by a nine-person Monetary Policy Committee, and Carney thought it would be a good idea to reduce uncertainty about the timing of increases in the bank rate – at 0.5 per cent it can hardly go down. Looking forward, the guidance was that bank rate would not rise until the unemployment rate had fallen to threshold of 7 per cent. The Bank’s economists forecast that this would not happen until early in 2016.
They got it hopelessly wrong. Like almost every other forecaster, the Bank failed to predict the spurt away from recession in the second quarter of 2013, since when unemployment has been falling steadily from 7.8 per cent to 7.1 per cent in January. It looks likely to reach the 7 per cent threshold this month, two years earlier than predicted.
Traders and brokers in the City of London, whose instinct is to jump to conclusions, have decided that the bank rate ought to rise some time this year. But this probably will not happen. Carney’s benevolent gesture, designed to reduce uncertainty, has thus increased it. Around half the economists question in a Reuters poll said forward guidance was too complex.
Carney appears to have no wish to hamper the remarkable rate of economic recovery in Britain – believe it or not, the highest in the industrialised world at the moment. Raising interest rates this year might do just that. Moreover, there is no need to raise them: inflation is on target at 2 per cent and wages are rising more slowly than inflation. What is likely to happen soon is a shift of the arbitrary 7 per cent unemployment threshold, down to 6.5 per cent.
Facing Parliamentary committees, Carney is a smooth and authoritative performer. But the first six months of his governorship have been neither.
Since his arrival in London, he has been critical of the quality of Britain’s economic statistics. A friend, who is immersed in drawing policy conclusions from banks of statistics, says: “Forecasters shouldn’t complain about the data any more than sailors should complain about the sea.”
Carney’s embarrassment reveals a truth about statistics. My friend adds: “All forecasts are driven by human judgement” – that is, they reflect the personality of the forecaster. And the Monetary Policy Committee’s decision about the timing of increases in interest rates will depend on the balance among the nine members who are either optimistic or pessimistic by nature.
They will be called to make a judgement about the damage inflicted by a recession now into its sixth year. One severe consequence is that productivity in the labour force has fallen by between 5-6 per cent.
If the recovery continues throughout this year – and the signs are promising – the forecasters will be scrutinising the speed with which unemployment continues to fall. A rapid decline will suggest that productivity remains weak, and that employers are increasing output by hiring extra manpower. As a result, bottlenecks will form in the labour market. Inflation would start to rise. The pessimists would increase interest rates without delay.
On the other hand, if increases in output use up spare capacity, unemployment would fall more slowly and the economy might get two or three years of grace before inflation becomes a problem. In that case, optimists will keep rates low for some time.
When he arrived at the Bank, Carney announced that he wanted to end the instinct for secrecy by making its operations more transparent. He has also said he wants forward guidance to evolve.
He might begin by copying the Federal Reserve board’s approach in Washington DC. They publish a dot chart on which members of the Board put a mark at what they consider to be the appropriate future level of interest rates. This gives an accurate picture of the range of expectations among a group that must eventually compromise to reach agreement.
It would avoid the arbitrary nature of the Bank of England’s forward guidance and still provide the City and Whitehall with a shrewd idea of the way the wind is blowing. That way, the Old Lady’s knickers need no longer be in a twist.
Stephen Fay is a former editor of Wisden and author of books about the Bank of England and the collapse of Barings.