There is a real chance Carney’s high stakes bet will end in tears
LET’S face it: monetary policy in the UK has become much harder to understand, in no small part because of Mark Carney’s botched forward guidance. Starting in the 1990s, and until the recession, most people, when asked what the Bank of England was trying to do, would have replied that it was seeking to control inflation through the use of interest rates. Some confusion was created when the target switched from the retail prices index to the consumer prices index (in both cases within a symmetric margin of error); but the public as well as professionals thought they knew what was going on. In truth, there were always caveats to the Bank’s supposedly single-minded pursuit of price level growth, but these were ignored in the public debate and the UK went through an exceptional period of policy clarity that hadn’t been seen for a very long time previously and that is unlikely to return in a hurry.
This happy world has now been shattered and confusion is rife. Hardly anybody, including a professional economist, could summarise today’s UK monetary policy in one sentence. The reasons for this are good as well as bad. Inflation targeting was actually a disaster and a deeply inadequate form of monetary policy, for all of its welcome simplicity; it allowed excessive liquidity to build up unchecked and to create bubbles in asset prices. The ensuing boom and bust was a major failing of monetary policy, a terrible error that was the direct result of Gordon Brown’s flawed monetary structure and of the Bank’s implementation of it.
But instead of ditching the framework completely, we now have a much more complex set of aims. Forget about the seven per cent unemployment threshold – the world’s now moved on. The Bank has restated its aims, so let’s quote them in full: “The MPC sets policy to achieve the two per cent inflation target, and subject to that, to support the government’s policies, including for growth and employment.” What does that mean? Without further context, nobody really knows; and clearly the phrase could mean different things to different people at different times. The bank’s dual mandate now resembles the Fed’s; and clearly inflation could be allowed to rip under certain circumstances.
As to the Bank’s thinking about the present state of the economy, it believes that despite the sharp fall in unemployment, there is still scope for the economy to grow before rates will need to go up; and when this does happen the rate hikes will be gradual (though of course even that could change).
Most radically of all – and in my view most dangerously – the Bank believes that even when the economy has returned to normal levels of capacity and inflation is close to the target, the appropriate level of the Bank rate is likely to be “materially below the five per cent level set on average prior to the financial crisis.” While this is meant to reassure and anchor rate hike expectations, I fear that this is the part of its statement that the Bank will most come to regret. How can anybody really know what the “right” interest rate will be in three years’ time?
The Bank now believes monetary policy to be merely the last line of defence when it comes to promoting financial stability – to be used only if risks cannot be contained by the Financial Policy Committee and its untested and hugely intrusive macro-prudential powers over bank lending.
So there you have it. The Bank thinks spare capacity is 1.5 per cent of GDP, that growth will be 3.4 per cent this year – but my reading of its forecast is that rates won’t go up until just after the general election, and that they will rise gently to around two per cent after that. Will Carney’s dovishness pay off, or will we end up in another boom and bust? Britain is engaged in a gigantic, high stakes bet on the future of the economy. It might just work out – but there is a horrifyingly high chance that it will all end very badly indeed.
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