Don’t Frighten The Horses

14/02/2014 at 4:25 pm

The most significant UK event this week was the release of the Bank of England’s latest Inflation Report and accompanying press conference. Mr Carney’s “forward guidance” on interest rates, introduced last year, came under particular scrutiny with unemployment now within sight of the 7% level originally identified as a precondition to tightening policy. This guidance – “open mouth operations” in City slang – has been broadened. In line with statements from the Fed, the Bank is making quite a strong effort as the recovery strengthens to contain expectations that its base rate will rise. From the introduction to the Report:

“The UK recovery has gained momentum and inflation has returned to the 2% target … employment gains have been exceptionally strong and unemployment … is likely to reach the MPC’s 7% threshold by the spring of this year. Even so, the Committee judges that there remains spare capacity, concentrated in the labour market.

Inflation is likely to remain close to the target over the forecast period. Given this … the MPC judges that there remains scope to absorb slack further before raising Bank Rate. 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.”

The message is clear. On the one hand the Bank has partially unwound one of its emergency monetary measures by taking residential mortgages out of the scope of its Funding for Lending scheme. The economy has picked up. On the other hand the Bank mustn’t frighten the horses by allowing premature expectations for rate rises to dampen confidence. Tighter credit markets and a stronger pound could undo the work of an accommodative base rate whose work against a fragile background is not yet done.

At the same time the Bank must justify its stance with an eye on the outlook for inflation. This is something it has woefully misjudged in recent years. Yet the argument remains the same: with spare capacity in the labour market there is no upward pressure on wages (which the data shows has been true) and so an increase in rates to tamp down demand is unwarranted.

This blog noted a few months ago that inflation is not yet on the world’s list of concerns. Indeed, in Europe the annual rate of CPI inflation has come in below 1% consistently since September and there is now talk of deflation in the eurozone. But in the UK prices have been much more stubborn. Can we really expect them to remain around the CPI target level of 2% over the next two years as Mr Carney’s model expects – the first time this will have happened since 2005?

We ought to have some sympathy for the Bank. Some of the inflation since the Great Recession has been attributable to VAT hikes, fuel duty and other indirect taxes. The question is: have these effects – which have nothing much to do with capacity in the labour market – really gone away?

When it comes to utility bills, for example, are we sure that costs due to capital investment programmes and environmental measures can be kept away from consumers? And is the impact of flooding on the price of food destined to be entirely negligible? There is also housing to consider. House prices are rising at over 5% on the ONS measure: over three times the average rate for 2012. For most months in 2011 they fell.

Governor Carney’s message on Wednesday saw bond yields and expectations for shorter-dated interest rates increase, and the biggest one-day rise in trade weighted sterling since last April. The market’s horses are not frightened, but nor are they discounting the eventual policy impact of the UK’s recovery entirely.

As conditions improve and risks remain, central banks have a tightrope to walk between destabilising recovery and fanning inflation. We must all hope they have a very keen sense of balance.


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