Without forward guidance, this would have been a very ‘dovish’ Inflation Report from the Bank of England, but we are now dealing with a central bank with two key policy pillars (CPI and unemployment) and markets have focused strongly on the latter. As such, the Bank has shot itself in the foot.
The near-term inflation forecast has been revised down “significantly” versus that published in August and on the 2 year horizon (using market rates), inflation is seen below target in 2 years, vs the above target projection in August. Normally this would have been a strong signal for the market to adjust rate forecasts lower and for sterling to fall as a result.
As it is, the better than expected labour market and GDP data has resulted in the time at which the MPC believes the 7% unemployment rate ‘threshold’ will be met being bought forward by 3 quarters. There was always scepticism at the time that the MPC were being a little too cautious on this.
As such, we’ve seen market rate forecasts revised higher (expecting the first tightening earlier than before) and sterling rally back to 1.60 against the dollar, as the market has placed a greater weight on the change in labour market projection vs. that for inflation.
But is this the correct response? The key issue is productivity. The labour data today showed hours worked rising in the third quarter and overall the picture remains of weak growth in productivity and negative real wage growth. So as with the US (owing to falling participation), the unemployment rate may be falling, but it’s not an overly positive message that emerges from it.
Ironically, if it were not for the forward guidance, market rates would have moved lower today, which would have eventually fed through to households and businesses. From this perspective, it’s pretty clear that forward guidance has not worked.