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.