The expectations were very high, and when it came to it, new Bank of England governor Mark Carney delivered. Reading the local press after the presentation of the Bank of England's August inflation report, the consensus was that the monetary policy in the United Kingdom has been given something of a radical makeover. In itself, the news that the BoE was to adopt the so-called "forward guidance" was not surprising. After all, Carney had been specifically hired to bring this policy framework over to the UK from his native Canada. The positive surprise was that, barely two months into the job, he seems to have taken effective control of the BoE machinery. Indeed, as revealed by the minutes of the policy meeting held on Aug. 1, the new governor's ideas count on an almost unanimous backing from his colleagues at the nine-member policy-setting Monetary Policy Committee (MPC) with the only dissenting voice expressing concerns about technicalities rather than opposing the new policy.
The whole point of forward guidance is to provide as much certainty as possible about the future path of interest rates so as to facilitate economic agents' (that is, consumers' and corporations') decision-making process. As such, the BoE has explicitly expressed its intention not to raise interest rates until the UK jobless rate, currently at 7.8%, falls to 7%. To the BoE's best judgment, this is unlikely to happen over the three-year projection period on which the August inflation report's economic forecasts are based. However, in order not to compromise the BoE's legally bound dual objective of price and financial stability, the guidance can be withdrawn at any time if inflation looks like getting out of control, or the stance of monetary policy poses a significant threat to financial stability that cannot be contained via regular supervisory and regulatory processes.
Taken at face value, as of now, UK interest rates should remain at the current historical low of 0.50%--or even lower--at least out to mid-2016. By providing this guidance, what the BoE is trying to achieve is an upward shift in domestic demand. Consumers should be more willing to spend than save, while corporations should be less averse to putting cash to work on investment projects. However, it is very important to underline that the forward guidance is ultimately an expression of intent and not a firm commitment. It is only valid as long as the macroeconomic forecasts on which it is based remain so, too. To that respect, the BoE has been proactively downplaying the latest round of positive economic data, both domestic and external.
UK GDP grew by 0.6% in the second quarter, well above expectations, while early indications for the third quarter (for example, UK manufacturing and services Purchasing Managers' Indexes for July are up to 54.6 and 60.2, respectively) do point to another punchy quarterly performance. Most forecasters--including the BoE itself--are upgrading UK GDP growth projections for 2013 and beyond. Meanwhile, the eurozone, the UK's key trading partner, is also looking on the mend. After six consecutive quarters of output falls, eurozone GDP grew by an estimated 0.3% during the second quarter. More so, the improvement was broad-based, in geographical terms. Germany and France delivered stronger-than-expected performances at 0.7% and 0.5%, respectively. As per the beleaguered periphery, both Italy and Spain recorded substantial decelerations in the pace of contraction, while forward-looking indicators suggest a return to growth, albeit mild, to be high on the cards for the second half of the year.
And yet, the message the BoE wants UK economic agents to focus on is that this remains the slowest recovery on record for all concerned. Or, to put it differently, "don't get carried away, we won't be changing the guidance we've just given you anytime soon." Only time will tell whether forward guidance proves successful at shaping economic agents' decisions in the manner the BoE hopes for. One can say with some certainty that going forward, financial markets, which pre-empt monetary policy moves and set market interest rates accordingly (that is, what economic agents actually pay), will be keener than ever to test the credibility of the BoE's macroeconomic forecasts--particularly those on inflation.
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