Bank guidance was a monumental mistake
Peter Warburton - 31 May 2018
As the years go by, the significance of the introduction of so-called forward guidance by the Bank of England in August 2013 has come into sharper focus. My initial reaction to this policy innovation was negative and my considered reaction is that it was a monumental mistake. The idea of providing individuals, businesses and financial markets guidance over the probable course of interest rates and asset purchases was not original, but copied from the Bank of Japan and the US Federal Reserve. The trigger for these remarks is Bank governor Mark Carney’s latest speech, “Guidance, Contingencies and Brexit”, in which he defends the use of guidance and attempts to justify why Bank Rate is at precisely the same level as 5 years ago.
The most important criticism of guidance is that it discloses too much information about the central bank’s decision-making process and obstructs the necessary – and sometimes sudden – changes of thinking and direction that are a healthy part of any organisation. At its worst, it creates a credibility trap, in which the policy committee cannot admit its own mistakes. Inadvertently, the Bank’s MPC has created such a high threshold of proof for an increase in Bank Rate that in almost no circumstances will it be reached. Its post hoc justifications for inactivity will not wash.
At the heart of this misguided strategy is the notion that monetary policy settings map on to unique outcomes for the UK economy, as they do in the Bank’s models. If the Bank was still in a 1970s world, pulling levers in a railway signal box, then all would be well. However, a better metaphor for the Bank in 2018 is not a signal box, but a junction box in the middle of a wiring diagram. Through its own actions and through its own faults, the central bank has allowed itself to become endogenous to the economic and financial system. This means that the impact of a given policy change is indeterminate, as the central bank is second-guessed by households, businesses and financial institutions.
The evolution of UK output growth and inflation over the past 5 years does not validate the decision not to leave Bank Rate unchanged in 2013, in violation of the counterfactual path suggested by historic correlations (see figure 1). There was clearly a middle road to be taken, acknowledging the ongoing need for structural repair in the wake of the global financial crisis, but seizing the opportunity to begin the normalisation of policy. Documented in my voting on the IEA’s Shadow MPC, I have been an advocate of modest increases in Bank Rate since early 2013 and have re-stated this case on many occasions since (see here, for an example).
I contend that the UK economy would be in a much stronger and healthier position today – to confront whatever terrors Brexit may or may not hold – had tightening begun 5 years ago. “Guidance” has endogenised policymaking and thereby diminished its effectiveness. Around the world, central banks are being played like fiddles by powerful financial institutions. More than that, unconventional monetary policy is having a cumulative, subversive, effect on private sector decision-making.
Figure 1: Forward market interest rates and counterfactual path for Bank Rate in 2013-14
Source: Bank of England (Carney speech, p6)
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