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Forex: Bank of England keeps digging

The Bank of England is in a hole and instead of climbing out, it has continued to dig. Recall, when forward guidance was introduced 6 months ago, there were several knock-outs, which allowed the Bank ‘wiggle room’ around its new 7.0% threshold level on the unemployment rate, above which rates would continue to be kept low. Six months on, with unemployment having moved close to the 7.0% level far faster than anyone anticipated, the Bank has introduced a lot more complexity to the policy outlook. As well as suggesting that rates will remain at the current level even when this unemployment rate is hit, the Bank has put an emphasis on the level of spare capacity in the economy, so suggesting that this will continue to be the case even when unemployment falls below this threshold. On top of this, the Bank is now forecasting 18 more economic variables, even though Carney admits that these forecasts will invariably be wrong.

This makes the policy calibration horrendously complicated and many will start to yearn for the days of a simple target (inflation) and single instrument (interest rates). Indeed, one of the rules of central banking is that you can only have as many instruments as you have targets. You can’t hit 3 targets simultaneously with one gun. The other factor is that the level of slack or spare capacity is very difficult to measure. You are comparing where the economy is now, to where it would have been (without the downturn) and also guessing to what degree capacity has been destroyed (labour loses skills, capital deterioration). The Bank took the view that spare capacity was going to bear down on inflation earlier in the recovery. Instead it moved higher and the Bank subsequently down-played the link between spare capacity and inflation. In the August 2012 inflation report, the Bank stated that “some of the sources of uncertainty affecting the outlook for growth may have only limited implications for spare capacity and hence inflation”.

The initial reaction has been for markets to price in rate hikes earlier than was previously anticipated. The Bank has erected a pillar for policy which is far harder to observe, forecast and understand than the previous one (unemployment), and introduced a fog of new forecasts to complicate matters further. The market has put a premium on the uncertainty that this has created (and supported the currency), despite the Bank’s attempt to dampen expectations of higher rates. In short, the Bank is digging, but with an even bigger shovel.

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