FORWARD GUIDANCE IS ALREADY HERE
In his annual budget in March, UK chancellor George Osborne asked the Bank of England to review the case for using so-called “forward guidance” in its August Quarterly Inflation Report (QIR). The expectation is that some form of forward guidance will be announced on Wednesday.
Back in March, the direction of the UK economy lacked conviction, and many were resigned to accept a “new normal” of stagnation. But since then, economic indicators have taken a more cheerful tone, giving rise to a new wave of optimism surrounding the UK’s economic prospects.
Purchasing managers’ surveys – a leading indicator of GDP output – have exceeded expectations as of late. The services PMI grew at the fastest rate since late 2006 in July; increased UK housing activity has dragged construction output growth to its strongest levels since June 2010; and manufacturing PMIs are sitting at 28-month highs too. And GDP – the acid test – came in slightly higher than the BoE’s projections in Q2.
This will also be Mark Carney’s first press conference since taking office in July. And markets will be keen to see how the new governor performs in front of the world’s media.
NOTE: Following the inflation conference, the Bank of England press office has confirmed that the Bank will be holding a technical briefing for external economists, providing details on how the BoE has reached its decision on forward guidance, and how any (possible) guidance should be interpreted. While some may effectively interpret this as a pre-announcement of forward guidance, it is worth bearing in mind that the briefing could easily be used to explain why forward guidance was not adopted.
POTENTIAL TYPES OF GUIDANCE
George Buckley, an economist at Deutsche Bank, believes that guidance could come in one of two forms: “loose-form,” which involves vague guidance (a ramped up version of what we have been getting), or “strict” guidance, which is tied to either a time frame or some economic measure (like employment conditions, for example).
1. LOOSE FORM GUIDANCE
Looser guidance in itself could take a couple of different forms: either the Bank could provide a combination of time and data-based guidance, for example, something on the lines of “the Bank intends to keep interest rates at their current level or below for a prolonged period and at least until the level of economic output has well surpassed its previous peak”.
Alternatively, the Bank could provide bank rate forecasts for the medium term (Buckley believes the next three years – similar to the Riksbank and Norgesbank). “This could be considered ‘loose-form’ guidance because it is a forecast, not a pre-commitment,” says Buckley, “and as we have seen those central banks currently using the procedure are not afraid to alter their forecasts regularly and substantially as the economic outlook changes.”
2. STRICT GUIDANCE
A) GUIDANCE ATTACHED TO A TIME-FRAME
Of the two, Buckley sees the Bank adopting the looser form. He sees problems with tying guidance to a set time frame: “The Bank would have to pre-commit for a very long period of time (probably until at least the end of 2015) in order to prevent a short-end sell-off,” he says, adding that “this may well be longer than some MPC members are willing to pre-commit for.”
Buckley opines that “the Bank needs to be vague in its prognosis of guidance. In other words, it will be ‘guidance’ in the truest sense of the word.” It is this type of loose guidance that will help to anchor the short-end of the rate curve, Buckley says.
B) GUIDANCE ATTACHED TO THRESHOLDS
Analysts at Barclays, however, believe that guidance will take a more conditional form, and expect the BoE to tie it to an unemployment threshold – like in the US – which, they argue, also “has the potential to provide a deep insight into inflationary pressures in the economy.”
But there are doubts over whether or not this threshold would work in the UK. Analysts at Societe Generale write “in the US, much of the fall in the unemployment rate from the post-crisis high has come about as a result of a strong and sustained fall in the participation rate. In the UK, that has not been the case. Indeed, the participation rate has actually risen gently over that period.”
The UK’s employment situation is already baffling economists. The so-called “productivity puzzle”, where unemployment has remained resilient despite falling productivity, cannot be definitively explained by one school of thought. SocGen say that if the productivity puzzle cannot be explained, one should be cautious in using employment as a yardstick.
SocGen’s analysts fear that “with domestic inflation pressures so insensitive to downward pressure from the large output gap, aiming for a much lower unemployment rate would risk increasing those [inflationary] pressures.”
C) GUIDANCE ATTACHED TO OUTPUT
Another option is to tie guidance to a measure of economic output: nominal GDP or an output gap threshold. In principle, the BoE could target nominal GDP output, but it would be riddled with questions.
For example, what target would the Bank select? The average long-term growth rate from the early 1990s is a shade over 5%, according to analysts at Societe Generale, but “it would be rash to use that as the threshold value,” they write. The issue is that GDP can be an unreliable measure of output in the short-term, and if the policy were to backfire, it may lead to much higher inflation.
But Rob Wood, an economist at Berenberg Bank, says targeting an output gap may be a more subtle way of targeting economic growth, and it would allow us to see where the Bank sees “normal” conditions.
RISK: NO GUIDANCE ANNOUNCED
Some caution that the announcement of forward guidance is not a dead-cert. Divyang Shah of IFR markets writes “while Carney is in favour of forward guidance, other members of the MPC seem not so convinced; so it’s not a given that forward guidance will be adopted,” he says.
It is likely that the market would interpret a lack of forward guidance as hawkish, and subsequently, we would expect to see sterling strengthen and equities soften. But it may also be taken as a sign of confidence in the UK’s economy, which has been picking up as of late, lessening the need for more monetary stimulus.
Our view, however, is that some form of forward guidance will be announced. “The Bank has alluded to forward guidance in the past,” says Harry Daniels, senior analyst at Live Squawk, “if they didn’t adopt it, the Bank risks losing credibility. It may also bring him at loggerheads with the chancellor.”
The truth is, forward guidance has already been introduced by stealth by the Bank of England. At its July monetary policy meeting, the BoE broke with tradition and issued a (proper) statement saying that “the implied rise in the expected in the future bank rate was not warranted,” which many have interpreted as guidance to assure the markets that rates will be kept low for some time.
Further, the fact that the Bank of England shows fan projections of inflation and growth can also be considered a form of forward guidance, according to some analysts. So while it is worth being prepared for the risk that the BoE will not announce guidance, the chances are very slim.
OTHER QUESTIONS ON GUIDANCE
What would back up the BoE’s guidance?
Hannah Wood, an analyst at Live Squawk, points out that forward guidance in the UK would be unlikely to take the form of guidance seen in the US. “Remember, the Fed is currently still making asset purchases; the BoE isn’t,” Wood reminds us.
It begs the question about how the BoE would back its claims to keep rates low in the event that external headwinds start putting upward pressure on them. The ECB’s untested OMT has the commitment that it will buy bonds in the event of an economic meltdown; the Fed has reiterated that its asset purchases are flexible.
There is no consensus about how the BoE would position itself. For example, would guidance have thresholds attached to restarting easing?
Could guidance be constrained by inflation?
In the US, the Fed is committed to keeping rates low until unemployment falls beneath 6.5%. But this commitment has been made as long as inflation doesn’t exceed 2.5%. And when Carney announced forward guidance in Canada, it was time dependent, but “conditional on the outlook for inflation”.
The BoE’s mandate is to target inflation – this has not been amended. Therefore, the market will want to know how any guidance would work in the context of inflation, and specifically, what measure of inflation? CPI (which the bank currently targets)? Core inflation? Inflation expectations?
Will guidance be given on the way up only, or on the way down too?
If any of the Bank’s targets for guidance are met, will it end the policy, or is it likely to be revised?
When will guidance begin?
While there is an argument that guidance is already here, when will the ‘new’ form of guidance be put into play?
With the debate focussed on forward guidance, it is easy to forget that the Bank of England will also be updating its inflation forecasts.
In its May QIR, the BoE noted that “the economic recovery remains weak and uneven” in the UK. It forecasted that inflation was likely to remain above target for much of the following next two-years, expecting inflation to fall back towards 2% “over time”. The Bank also noted that the “risks to inflation are broadly balanced around the 2% target in the latter part of the forecast period”.
In terms of economic output, the Bank correctly saw GDP coming in at 0.3% in Q1, and was close with its Q2 prediction of 0.5% (the actual reading came in at 0.6%), which it described as “moderate growth”. Looking ahead, it saw annualised growth rising to 2% before May 2015.
GROWTH OUTLOOK MAY BE RAISED
As noted, the pessimistic assessment of the UK economy no longer seems warranted, given the improvements in economic indicators. Some, therefore, argue that it is likely that the Bank will raise UK growth forecasts for 2013 and 2014.
The implication of a higher growth outlook may be higher inflation in the future. Rob Wood, an economist at Berenberg Bank, argues that a more cheery growth forecast “will lead to modestly higher inflation at the two-year mark,” pointing out that the “the Bank is still an inflation-targeter, so inflation is still likely to return to target by the end of the BoE’s three-year forecast.”
To manage these expectations of higher growth, which would be unlikely to materialise if rates picked-up too quickly, Wood posits that the Bank will again use forward guidance to anchor rate expectations: “The BoE’s job now is to use guidance to ensure that the stimulus is not withdrawn prematurely,” he says, adding “now is the time that guidance is important, as it can dampen any expectations of rate rises.”
Analysts at Investec say they will also be watching whether any raised growth forecast will be accompanied by guidance on asset purchases. “Given, that the MPC opted to hold policy [at its August meeting], we are curious to see whether the Bank’s updated inflation projections close the door to further easing, adding to expectations that the MPC is now more focused on ensuring it does not withdraw stimulus too soon, rather than reinforcing the recovery with more stimulus.”