From The Financialist

In announcing last August that it would be continuing its program of loose monetary policy until British unemployment levels have fallen to 7 percent, the Bank of England (BOE) intended to assure British households, businesses and investors that interest rates would remain low enough to support a nascent economic recovery for several more years. The central bank, after all, doesn’t see unemployment dipping below that threshold until 2016. But the message wasn’t as convincing as the bank’s Monetary Policy Committee (MPC) had clearly hoped it would be, and post-announcement trading indicated that the markets believed interest rates would rise sooner rather than later.

The bank’s statement marked the first time it had issued forward guidance to give markets a line of sight into the trajectory of future monetary policy, something the U.S. Federal Reserve has long done, and it was a noteworthy demonstration of new central bank governor Mark Carney’s decision to begin telegraphing the BOE’s intentions. Markets were expecting the move. Chancellor George Osborne had asked central bankers to weigh in on forward guidance in August, and Carney has been an evangelist for such guidance since successfully introducing it in his erstwhile role as Canada’s chief central banker.

There are two reasons the message came out muddled. The first, Credit Suisse’s Head of European Economics Neville Hill explained in a note called “Cautious Guidance,” was the inclusion of “knockout clauses” that gave the Bank of England room to abandon its forward guidance should inflation expectations rise too quickly or if current monetary policy were deemed to pose a “significant threat to financial stability.” Specifically, the central bank said it could consider abandoning forward guidance if inflation is still higher than 2.5 percent in 18 to 24 months, or if five-year inflation forecasts start to move steadily higher. That worried markets because with the official bank interest rate set at a record low 0.5 percent, inflation hit a 14-month high of 2.9 percent in June compared with 2.7 percent in May.

Still, Credit Suisse’s Hill said markets are overreacting to the possibility that high inflation will lead to early rate increases. The BOE itself assigned 40 percent odds to inflation remaining above the 2.5 percent knockout level two years from now and said it expected inflation to decrease to the 2 percent target level in mid-2015, the end of the target period. The unlikely scenario that could trigger the knockouts, Hill said, would involve “a substantial, broad-based rise in inflation expectations across a broad range of business and consumer surveys, especially if it was accompanied by a sharp decline in sterling and rise in break-even inflation rates in fixed-income markets.” Hill also pointed out that the bank’s Monetary Policy Committee (MPC) is responsible for coming up with the inflation forecasts around which the knockout clauses are based, so central bankers have plenty of leeway to keep monetary policy as is until they see fit to begin tightening by slowing asset purchases or raising rates. Besides, the MPC’s 18- to 24-month outlook has not called for inflation above 2.5 percent at any point in the last nine years – even before the most recent period of relatively high inflation. The committee is unlikely to start making such hawkish forecasts while forward guidance is in effect, Hill wrote.

But markets do have another reason to worry that the dovish stance could end earlier than telegraphed – the higher-than-expected unemployment threshold that Carney and the Monetary Policy Committee chose as an economic goalpost. The U.K.’s jobless rate currently stands at 7.8 percent – not far from the 7 percent target. Credit Suisse had expected a 6.5 percent threshold, identical to the one the Federal Reserve has adopted in the U.S. While Hill noted that 7 percent is still well above pre-financial crisis levels, the central bank has argued that structural unemployment – a stickier form of unemployment that reflects a fundamental disconnect between available jobs and workers willing and able to fill the jobs – is higher now than before the downturn.

Still, the U.K. economy is picking up, so unemployment levels should soon improve. The only question is by how much. The Markit/CIPS services purchasing managers’ index survey showed that in July, Britain’s services sector grew at a faster rate than it has since 2006, while business sentiment also reached a 15-month high The Bank of England expects economic growth to hit 1.5 percent in 2013 and 2.7 percent in 2014, up from May’s forecast of 1.2 percent and 1.9 percent. “Although the expected growth rate is not particularly strong by historic standards, it does imply a significant and sustained acceleration during the upswing,” Hill wrote. “Consequently, we think there’s a good chance that unemployment falls faster than the MPC anticipates, and in coming quarters, the MPC’s best estimate of when unemployment will fall below 7 percent is steadily brought forward.”

To the extent that forward guidance was intended to reassure both investors and households, it might have done so for some. But it certainly didn’t solidify a consensus. Still, given the prevailing confusion among ordinary Britons about the future of monetary policy and interest rates, some sort of messaging was desperately needed, as Hill noted this week in a call with investors before the Bank of England announcement. “When one-third of the U.K. population still thinks interest rates are going up in the next 12 months, I think giving a very clear and specific message will be very important in increasing its impact beyond financial markets to economic agents more broadly in the U.K.,” Hill said. Even if the message is a little muddled, the central bank still has plenty of tools to begin tightening policy only when it judges the economy to be truly ready. Both the unemployment threshold and the inflation “knockout” clauses are not automatic triggers – they’re flags for the central bank to start reviewing its options, Hill explained. At least investors and the British public now know what to look out for.

Photo courtesy of Bank of England via Compfight

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