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Carney’s forward guidance takes a backward step

GIVEN THE CONTEMPT directed towards bankers in recent years, the positive welcome given to Mark Carney, the new governor of the Bank of England, was remarkable. He is certainly a different character from his predecessor, the donnish Sir Mervyn King.

While Carney’s academic record is every bit as robust as King’s, his private sector credentials (ten years with Goldman Sachs, some of it in London) are impeccable. Cut from the same cloth as Mad Men’s Don Draper, he certainly looks the part, and his record as a central bank governor in Canada suggested a smooth operator who understood the levers of policy. Hailed by chancellor George Osborne as ‘the outstanding central banker of his generation’, the media bought into Carney’s appointment. All he had to do was deliver.

In his first few months, the governor has come up with a policy called ‘forward guidance’, an approach used by the US Federal Reserve since 2008 that he adopted in Canada. Even the European Central Bank is following suit. The key to the policy is to give some assurance to markets about interest rate stability. Carney has said the Bank would not consider raising interest rates until the unemployment rate has fallen to 7% or less. With the rate currently at 7.8%, this implies somewhere in the order of 750,000 new jobs (in reality closer to one million in the private sector, given the squeeze on the public sector). The Bank believes this goal will not be achieved until 2016. Carney is also hoping to convert lower short-term interest rates into lower long-term interest rates.

So Carney’s primary task is to ensure the nascent recovery stays on track and is not stalled by a premature rise in interest rates. The chancellor accepts that fiscal policy has a very little role to play in the day-to-day macro management of the economy and is looking to the Bank for the necessary fine tuning. The governor is sending a positive signal to borrowers but inevitable negative vibes to savers. He has also extended King’s remit, which was linked only to an inflation target, by adding unemployment into the mix. He has perhaps ended the need for the jamboree that is monthly meeting of the Monetary Policy Committee (MPC), a costly process which has left interest rates unchanged since March 2009. If they are going to be left on hold for another few years, what purpose is the MPC serving?

All of this makes it seem a bold start, but the critics are picking holes in his approach. A rise in the yield on ten-year government bonds was not the vote of confidence he wanted. In fairness to his predecessor, King was no pointy-headed inflation hawk. For over two years, the annual rate of CPI inflation was above the target range, and for two years, interest rates were left on hold. This implies that the MPC put a higher priority on recovery than it did on an inflation rate, that was partly caused by imports and government policy (the VAT increase)and which would not necessarily be responsive to higher interest rates.

In some ways, Carney is batting on an easier wicket, since it seems the recovery is underway and the need for urgent rescue action has passed. But this holds some dangers for his policy stance. What if growth is stronger than the Bank expects and unemployment falls faster? This is pretty much what markets expect and the first interest rise has been priced in earlier than 2016. There are other ‘knock-outs’, related to inflation, asset price bubbles and financial stability, which give the governor a great deal of flexibility to the extent that, in the opinion of some commentators, the real effectiveness of forward guidance is diluted.

After the hype surrounding his arrival, Carney must come to terms with a financial sector that is bigger and more aggressive than he was used to in Canada. The press is predicting a governor v markets battle, over rates in the coming months. But he seems as cool as the publicity implied and is unlikely to be fazed by this early spat. Bigger tests await him further down the road.

Dennis Turner is the former chief economist at HSBC

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