When it comes to bold predictions of interest rates, markets and economies, markets… you can’t help but let out a sigh of exasperation.
If we knew with any certainty what currencies or interest rates might do over the next two years, much uncertainty would be removed from investing, the future would hold fewer terrors – and we could all be seriously rich.
Little wonder a small army of economists, stockbrokers, fund managers, analysts and assorted pundits has been trying its hand at this for as long as we can remember. That they are still at it – and that investors are little better off – tells us something about the triumph of hope over experience. The future may not always be unknowable, but it is unknowable for long enough to make mince of the most confident predictions.
I set all this out ahead of a startling development at the Bank of England in the next few days: it is planning to tell us what interest rates are likely to be two years from now.
When private pundits set out their predictions, we take them or leave them. But when the Bank of England enters this field, we must sit up and listen. It has got the licence to print money. It manages the national debt. And it is the lender of last resort. Its predictions have real consequences. And they must be more reliable, mustn’t they?
We should hear more of this new initiative in the wake of this week’s rate-setting meeting. It’s called “forward guidance”, an idea that new governor Mark Carney hopes will help make monetary policy more effective.
The plan is that the Bank’s monetary policy committee will tell the world not just at what level it intends to fix short-term interest rates, but for how long. The idea is that if it says it plans to hold rates at today’s ultra-low level of 0.5 per cent level for, say, two years, then long-dated rates will also stay low, giving more confidence to business and personal borrowers alike. Wouldn’t this be a wonderful thing? Little wonder that the Bank’s first forward guidance is awaited with such excitement.
It’s such an obviously good idea you can’t help but ask why it hasn’t been done before. And here we come to the first flaw. Interest rate forecasting is a fool’s errand. For periods – sometimes quite long periods – it can look easy. We can read the runes. But a brief glance at the history of markets will soon remind us how quickly the clearest horizon can disappear.
Interest rate movements are constantly subject to forces that are, by their nature, unpredictable and which can bring sharp and immediate reaction. External events, or changes in the outlook for the global economy, can cause sterling to move and force a change in interest rates. Or there might be a change in the domestic economy, or a political crisis, or a move upwards or down in commodity prices or North Sea oil revenues: any of these can render the most reasoned interest rate forecasts of just a few weeks ago highly vulnerable.
And why should the Bank’s forecasts be any better than those sweated over by all those highly-paid private sector economists and bond market analysts whose reputations are regularly on the line? Rate forecasting is no reliable science. Consider the current historically low rate of 0.5 per cent. When it was first introduced in March 2009, the consensus prediction was that it was an emergency level unlikely to last for more than a few months. In fact, it has lasted more than four years – 52 months, to be exact. We have become only slowly wise to the scale and depth of the recession flowing from the banking crisis. Perhaps it is not forwards guidance we need, but backward guidance!
The plunge by the Bank into long-range rate forecasting may not just be prone to error, but highly damaging to its reputation and to the conduct of monetary policy.
As the economist Andrew Smithers points out, what will happen to the credibility of the Bank should its guidance lead the market up the garden path? Why would markets pay the slightest attention to future pronouncements by the Bank?
Such attempts at interest rate pre-determination also pose a hazard to the Bank’s remit to target 2 per cent inflation. It sets up a conflict between sticking to the “forward guidance” pledge and acting swiftly to head off an incipient inflation threat. Such a delay would undermine credibility in monetary policy and cause markets to question what is really the big determinant of policy: the inflation target, or the desire to stick by forward guidance in a vain attempt not to be proved wrong?
Thus it is that the consequences of such guidance could be long-lasting and severe – and the opposite of what Mr Carney is seeking to achieve.
If the Bank is to avoid being held hostage to fortune, it is likely that the forward guidance will be accompanied by a lengthy list of caveats and conditions. These are effectively escape hatches by which the Bank can avoid public embarrassment over its predictions. And when the “guidance” is read in full, will we really be much the more certain as to the future course of interest rates? Look at the history of prediction thus far. It tells us all we need to know.