Stronger growth points to review of the Bank’s forward guidance policy

Andrew Sentance
Follow Andrew
THE UK economy is looking up – it’s official! The Bank of England delivered a hat-trick of good economic news yesterday in its latest Inflation Report projections. Economic growth is looking stronger, inflation is coming down more quickly than expected, and unemployment is now projected to be lower than in the previous forecast in August.

The Bank’s latest forecasts for growth and unemployment reflect the strong economic data we have seen in recent months. Almost every indicator for the UK economy has improved significantly over the last six to nine months. In February, the Inflation Report forecasts suggested that economic growth would struggle to pick up to around 2 per cent a year by early 2016. Now, the Monetary Policy Committee (MPC) is forecasting growth of nearly 3 per cent next year and around 2.5 per cent in 2015 and 2016.

Stronger growth also means unemployment is expected to fall more quickly. Just three months ago, the Bank was suggesting that unemployment would remain above its 7 per cent threshold rate until at least 2016. The latest forecasts suggest this key threshold will be reached in mid-2015. But if the jobless total continues to fall at the same pace as it has done over the past three months, the unemployment rate will be below 7 per cent in the second half of 2014.

All this would seem to suggest that the Bank should be preparing the ground for rising interest rates. The current official interest rate of 0.5 per cent was set in March 2009 to turn around the economy in the depths of the global financial crisis. The recovery was held back in 2011 and 2012 by the effects of the euro crisis. But it is now gathering momentum again. Surely it is now time to start edging interest rates up?

That was not the tone of Mark Carney’s comments yesterday at the Inflation Report press briefing, as he sought to play down the prospect of interest rate rises in the near term. It was only a few months ago that the Bank launched its policy of “forward guidance”, which was aimed at persuading the public and businesses that interest rates were not set to rise for at least two to three years. But monetary policy needs to be prepared to adapt to changing economic circumstances. And it is not too difficult to see the economic conditions which are needed to trigger a review of the Bank’s current policy being met next year.

First of all, if growth gathers momentum, unemployment could fall below the 7 per cent threshold rate in 2014, rather than in 2015 as the Bank’s Inflation Report suggests. Indeed, as I noted earlier, if unemployment continues to come down at the same rate as it has done over the past few months, we should see a drop in the unemployment rate below 7 per cent in the space of less than 12 months.

Second, the Bank’s “forward guidance” framework contains an inflation “knock-out” condition. Though the recent news on inflation has been positive, there are a number of factors which could push inflation up from its current 2.2 percent rate, including the recently-announced round of energy price rises. If the world economy strengthens in 2014 and 2015, as forecasts suggest, we could see renewed upward pressure on the price of oil, food and other commodities. In addition, wage growth has been remarkably subdued since the financial crisis. With economic growth picking up and unemployment falling, wage increases are likely to recover, and employees may also try and recoup the squeeze in living standards they have seen in recent years.

Finally, the upward pressure on house prices could gather momentum, as the impact of the government’s Help to Buy scheme is felt in the housing market. This could trigger concerns about a housing bubble threatening the stability of the financial system – another condition which could result in a review of the current MPC policy of not raising interest rates.

The improvement in the prospects for the UK economy over the course of this year has been impressive and encouraging. But the job of the Bank of England is to keep the economy on a steady and stable course, so that the recovery in economic growth can be sustained. The risk of delaying too long in raising interest rates is that they then need to rise sharply in the future – triggering the type of shock to the economy which the MPC should be trying to avoid.

Andrew Sentance is senior economic adviser at PwC, and a former member of the Bank of England’s Monetary Policy Committee.