POLITICS

Will Mark Carney's Fuzzy Interest Rate Forward Guidance Help?

12/02/2014 17:34 GMT | Updated 18/06/2014 15:59 BST

Mark Carney's big change to his forward guidance policy on interest rates was to dump the 7% unemployment rate as a marker at which policymakers would consider hiking interest rates, after the unemployment rate fell just shy of it.

Carney insisted a more "nuanced" form of interest rate policy was needed, rather than a single threshold used by the Bank for six months that it described as "well understood".

This means the Bank would monitor 18 economic indicators to close the UK's so-called "output gap" of slack in the economy, indicating it is not operating at full capacity, like unemployment, labour market participation, average hours worked, the extent of involuntary part-time workers, labour productivity and wages.

In what critics have dubbed "fuzzy guidance", Carney's policy will see rate-setters try to eliminate the "wasteful" spare capacity in the economy over the next three years, which it estimates to be worth around 1 to 1.5% of Britain's GDP. Only then will the Bank follow its plan to raise interest rates gradually as high as 1.9% by 2016.

Despite Carney's insistence that forward guidance will remain well understood by businesses and the public, the Bank of England last August poured scorn on focussing interest rate policy on the output gap as they argued it "does not perform well from a data or communications point of view".

The Bank added: "The output gap is unobservable and difficult to explain, and any estimate would be subject to substantial uncertainty. That would make it hard for the public to understand the guidance."

Some businesses already agree with the Bank of England's scepticism. John Salt, director of the UK's largest employment site totaljobs.com, told HuffPostUK: “The Bank of England’s decision today has made the whole issue of interest rates more confusing for UK businesses.

"The 7% unemployment threshold was a straight forward indicator which everyone was broadly comfortable with. Now, with several assessments to consider, we have a foggier forecast which will disrupt businesses’ financial planning and create further uncertainly in the economy.”

Carney's new forward guidance still reassures some businesses as it makes clear that interest rates will stay at their 0.5% emergency low for the near term. But the Bank governor risks being overgenerous in estimating how easily his new forward guidance and its 18 indicators will be understood.

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According to a poll released by the Bank, less than half of businesses thought that interest rates would stay lower for longer - which was the deliberate point of Carney's forward guidance while the unemployment rate stayed above 7%.

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Meanwhile, less than a quarter (23%) of the public who were polled understood the Bank's message that rates would remain lower for longer, with around 13% thinking the opposite and expecting interest rates to rise sooner.

"As if the market needed any more distractions to skew their view of where exactly interest rates will be in the future," notes Eimear Daly, head of market analysis at Monex Europe.

This means more businesses and Britons could be left bamboozled by Carney's more complex policy for the direction of interest rates.