By James Zuccollo | 1 May 2013
It’s all change at the Bank of England with a new governor about to take over the reins and a revised remit from the chancellor. So can Mark Carney deliver?
The UK is in an economic hole. It remains mired in the longest recession for more than a century, and growth forecasts have again been revised down. The government’s 2013 Budget appeared to hoist the white flag, with the Office for Budget Responsibility assessing that it would have no effect on growth.
All eyes are now pinned on the much-heralded arrival of Mark Carney as the new governor of the Bank of England. He takes the reins from Sir Mervyn King at the end of June and will be the first foreigner to lead the Bank since its establishment in 1694.
In his current role as governor of the Bank of Canada, Carney has been credited with shepherding the economy through the financial crisis relatively unscathed. His use of unorthodox instruments, such as a year-long commitment to low interest rates, has been emulated by other central banks around the world. That boldness has generated intense speculation about the course UK monetary policy might take under his leadership, which has culminated with the release of an updated remit for the Bank of England alongside the Budget.
Announcing the 2013 Budget, Chancellor George Osborne said the ‘central plank of our economic plan [is] that a tough and credible fiscal policy creates the space for an active monetary policy’, a clear call for looser policy from the Bank of England. Of course, the Bank has not been idle since the crisis began. Since 2007, it has cut interest rates to historically low levels, conducted £375bn of quantitative easing and attempted to provide cheap lending to retail banks. Despite this, the economy has stubbornly flatlined and inflation has twice exceeded 5% since 2008.
Against this backdrop, the new remit for the Bank has two notable elements. It encourages the use of ‘forward guidance’, and clarifies that the target is ‘flexible’. These tools have always been available to the Bank but the chancellor has now highlighted them and, in particular, asked the Bank to report back to him on the use of forward guidance.
Forward guidance involves the Bank publicly committing itself to a particular course of action, as the Bank of Canada did in 2009 under Carney’s leadership. The idea is that a rule-based commitment allows people to act with more certainty about future economic conditions, which can help boost confidence and growth. It has been recently used in the US, where the Federal Reserve (the Fed) has committed to keeping interest rates below 0.25% as long as unemployment remains above 6.5% and inflation expectations remain below 2.5%.
Essentially, the Fed is promising not to put the brakes on until the economy is well on the way to recovery. In the UK, under the current governor, the Bank of England has steered clear of binding its hands in any way, but the chancellor is clearly hinting that he thinks it should reconsider its stance.
The new remit also confirms the Bank’s policy target as 2% inflation under the Consumer Prices Index. The chancellor has clarified that this means the Bank should always aim to return inflation to 2% in the medium term, not that inflation should be 2% at all times, regardless of economic conditions. That is welcome because it means that the Bank need not respond instantly to every wobble in the CPI.
As deputy governor Paul Tucker has said, ‘we don’t have to create recessions to get inflation back to target quickly in the event of an oil price hike.’ The Bank’s tolerance of spikes in the CPI over the past five years has been heavily criticised by some economists for breaching the target. The chancellor’s statement represents a strong rebuttal of that view.
With a new remit, the chancellor hopes the Bank of England will be able to resuscitate the economy. However, he might have overestimated its effectiveness. While the remit reaffirms the 2% inflation target, it does not provide any tools that were not available before the Budget. In essence, Osborne has simply hinted at what he would do if he were running the Bank. He appears to be hoping that a nudge towards further monetary easing and a new governor will be a sufficient impetus to alter the current direction. Carney appears to share these hopes, but both he and Osborne may be disappointed.
Decisions at the Bank are not made by a single person, and the governor has only one vote. Monetary policy at the Bank is decided on by the nine-member Monetary Policy Committee, and Sir Mervyn King has voted in favour of further quantitative easing at the past two meetings. King has a reputation as a forceful advocate for his views so it is unlikely that Carney will be better able to persuade the MPC to ease policy. It is neither the current governor nor his tools that are holding back monetary policy: the constraint is the target the chancellor has set.
A flexible inflation target might be the theoretical ideal but its implementation in the UK demonstrates its practical limitations.
To see the problems with the inflation target, we have only to look at the minutes from the MPC’s March meeting. They begin by pointing to ‘a degree of slack in the economy’, which is exactly what monetary policy exists to avoid. Of course, the committee must also heed inflationary dangers, but they note: ‘Higher output growth would not necessarily lead to any material increase in inflationary pressure.’
This suggests an immediate need to loosen monetary policy yet the committee eventually concluded that ‘there was a risk that [loosening] could lead to inflation expectations drifting upwards’, and decided not to act. Essentially, they judged that the risk of a possible rise in inflation expectations matters more than the near certainty that the UK has persistently deficient demand. In the current economic circumstances, it would be far better for the MPC to place its emphasis on assisting the economy to reach full capacity. That requires reframing its decision with a new target that shifts the balance of its attention.
The debate around appropriate monetary policy targets has flourished over the past five years and a number of alternatives were available to the chancellor. The most obvious alternative, championed by prominent economists such as Simon Wren-Lewis of Oxford University, would have been to give the Bank a dual mandate that requires it to consider both growth and inflation.
The Fed, for example, is required to both control inflation and reduce unemployment. That would change the balance of the MPC’s decision when weighing the risks to inflation against the costs of chronic demand deficiency. It would also be a relatively small change from the present regime and has the advantage of being well tested overseas.
In the present circumstances, it is almost certain that such a policy change would result in the MPC loosening monetary conditions. However, some commentators, such as HSBC chief economist Stephen King, complain that the Bank is out of ammunition because the headline interest rate is already close to zero and quantitative easing has been disappointing.
That complaint is a fair one in current circumstances but does not account for the powerful effect of committing to a new policy regime. In the UK, markets are unconvinced by the Bank’s efforts to stimulate the economy precisely because they know the MPC’s key concern is not growth but inflation. Cheap money today is a punch bowl that will be pulled away at the first sign of rising inflation, making it completely ineffective as a policy tool. A change in the policy regime changes the rules of the game.
The best recent example is in Japan, which has experienced two decades of economic stagnation. In that time, the Japanese government has racked up the world’s highest public debt (well over 200% of GDP) in an attempt to stimulate the economy. However, the Bank of Japan leaned against the stimulus and kept inflation at 0%, resulting in the lost decades. Late last year, the government changed tack and instructed the Bank of Japan to pursue 2% inflation; a massively stimulatory programme of monetary expansion compared with the previous policy. Since the announcement in November 2012, the Japanese stock market has risen 45% on expectations of future growth and the yen has depreciated by 20%, graphically illustrating the power of a policy change.
A more drastic change in target for the UK would have been a switch to targeting nominal output instead of inflation; so-called NGDP level targeting. Economic professors Michael Woodford, of New York’s Columbia University, and Scott Sumner, of Bentley University, Massachusetts, are notable proponents of nominal output targets, which have rapidly gained prominence since the onset of the recession.
Nominal output comprises GDP growth and inflation so it is somewhat similar to a dual mandate, only with a fixed ‘weighting’ between inflation and growth. Proponents of this target claim that its advantage over a dual mandate is that it provides a firm anchor on market expectations. Rather than having to guess at the MPC’s future actions, people can rely on a particular rate of income growth when setting prices. It is unsurprising that the chancellor decided against a nominal output target since no central bank has yet implemented one, despite its popularity among economists.
So a lot rests on the appointment of Mark Carney. The news that he is to replace Sir Mervyn King as the governor of the Bank of England has been met with almost universal praise. It is seen as a coup for the chancellor and an opportunity to lift the UK out of five years of recession. But rather than seizing the moment, the chancellor has left the new governor with all the weight of public expectation and little hope of fulfilling it.
James Zuccollo is senior economist at the Reform think-tank
