The Bank of England abandoned its strategy of linking interest rate policy solely to unemployment yesterday, as it stressed any rise from historic lows would be “gradual and limited” to avoid derailing the recovery.
Bank governor Mark Carney also said that even when base rates did eventually rise they would remain well below a pre-crisis average of 5 per cent for some time because of significant slack in the economy.
In its quarterly inflation report, the Bank said prices were likely to be benign between now and 2016. “Given this, and with spare capacity remaining, the monetary policy committee (MPC) judges that there remains scope to absorb slack further before raising Bank Rate,” the report said.
“Moreover, the continuation of significant headwinds – both at home and from abroad – mean that Bank Rate may need to remain at low levels for some time to come.”
Unveiling the Bank’s forward guidance policy last August, Carney said that it would not even consider raising interest rates until unemployment had fallen to 7 per cent – which it did not expect to happen until 2016.
But he said yesterday that unemployment had fallen much faster than thought and the Bank now expected it to hit 7 per cent this spring.
Outlining a revised forward guidance policy, the governor said the Bank would look in future at a wider range of 18 indicators, including wages, productivity and spare capacity within the economy. The inflation report said the MPC believed that the slack in the economy was “equivalent to around 1-1.5 per cent of GDP and concentrated in the labour market”.
Saying the Bank had “learnt along the way” regarding forward guidance, the governor added: “We have taken stock. We’re still looking to maintain the momentum of the recovery, but we have to make more nuanced judgments.”
He said the MPC had realised last summer that unemployment was not a comprehensive benchmark of economic spare capacity, but had chosen it because it was widely understood and did not get “revised” as much as some other data.
At a London press conference, Carney defended forward guidance, claiming it “is working... uncertainty about interest rate levels has fallen.” He said the policy had encouraged businesses to hire and spend.
But the policy was finite, Carney said. “The objective is not to have forward guidance forever. The objective is to have an economy that moves into sustainable expansion. We want to move from the recovery phase to the expansion phase.”
The governor refused to give any “time-contingent” guidance on when rates would rise from their current level of 0.5 per cent – where they have been since March 2009.
But sterling firmed on the foreign exchanges yesterday, with the Bank’s bullish growth forecasts for the economy this year of 3.4 per cent leading the City to believe the first rate rise will come in the spring of 2015. The UK economy grew 1.9 per cent in 2013, the strongest annual growth for six years.
The Bank report also said its bond-buying programme to stimulate the economy, which stands at £375 billion, would continue at least until rates had begun to rise. Carney said a “disappointing” aspect of the economic recovery was poor productivity, which the Bank did not think would get back to its pre-crisis levels for another three years.
However, after years of flat or declining earnings, the Bank said it believed there would be earnings growth in the second half of 2014.
Katja Hall, chief policy director at the CBI employers lobby group, commented: “There is still considerable slack in the economy, so now is not the time to raise interest rates, as the governor made clear.”