Interpreting the MPC’s forward guidance

Yesterday the MPC of the Bank of England announced its long-awaited forward guidance. It stated that the MPC does not intend to raise policy rates from their current level, or reduce the stock of its asset purchases (and so continue to reinvest maturing gilts) at least until the UK unemployment rate had fallen to 7%. That was subject to three knockout clauses, two of which related to inflation risks:

–     The MPC assesses that it is more likely than not that CPI inflation in 18-24 months will be 2.5% or higher.

–     Medium-term inflation expectations no longer remain well anchored.

–     The Financial Policy Committee (FPC) judges that the stance of monetary policy poses a significant threat to financial stability that cannot be mitigated by actions by the FPC.

If those “knockout” clauses are triggered, then the MPC would no longer stand by the forward guidance described above.

In the Inflation Report, the MPC produced two probability-based charts to add a time dimension to the forward guidance. The first showed the MPC’s assessment of the cumulative probability that unemployment would fall below the 2% threshold. It only moves above 50% in mid-2016 suggesting that, in the MPC’s collective best judgment, policy rates could remain on hold for the next three years if the “knockouts” weren’t triggered. Then there’s the probability of CPI inflation being above the 2.5% “knockout” threshold and on the current 18-24 month horizon, that probability is seen to be around 40%. Interestingly, that probability is projected to drift down over subsequent quarters.

As such, it seems that the message that the MPC wished to convey was that, in its best judgement and based on the evidence prevailing at present, it expects to keep rates on hold for the next three years. At face value, that’s a dovish statement but understandably, the market focused on the caveats, and in particular, the two conditional “knockout” clauses relating to inflation and both inflation “knockouts” are, to a large extent, dependent on the judgement of the MPC. Thus the Committee forecasts inflation and assessing a range of indicators, and absent a fairly specific set of factors, in particular, a sharp fall in sterling accompanied by a large rise in market expectations for UK inflation, we would not expect these “knockouts” to be triggered.

Equally, both the threshold and the “knockouts” provide conditions in which the state of “forward guidance” is over but policy would not automatically tighten if and when they were breached or triggered.

But, where the MPC’s message is more at risk is the unemployment threshold of 7%. That was higher than most expectations that centred on a threshold at 6.5% and is only three quarters of a percentage point below the current rate. Against a backdrop of a recovering economy, there must be a considerable risk that unemployment falls to that threshold rather sooner than the MPC expects.

Whilst the MPC’s choice of threshold was relatively hawkish, its forecast of when unemployment would fall to that threshold was extremely dovish, but a forecast is much less concrete than a threshold and the threshold is well above the unemployment rate that prevailed in the pre-crisis years. This is in large part because the Bank judges that structural unemployment rate has risen, but although the unemployment rate has been stable around its current rate for some time (and the short-term monthly measure shows no clear sign of a downtrend), the sharp improvement in cyclical indicators in the last few months raises the distinct possibility that unemployment may well soon start to fall. In effect, the time it’ll take for unemployment to fall to its threshold will depend on the strength of GDP growth and the strength of productivity growth. The faster the former and weaker the latter, the sooner unemployment will dip below the threshold. If the recent upswing in cyclical indicators is sustained, then the MPC’s forecasts for growth may prove too low and there’s real risk to its productivity growth forecast. The expected growth rate is not particularly strong by historic standards but does imply a significant and sustained acceleration during the upswing, so there must be a good chance that unemployment falls faster than the MPC anticipates, and in coming quarters, the MPC’s best estimate of when unemployment will fall below 7% is steadily brought forward.

Although the “knockout” clauses have caught the attention of market participants, they are remarkably similar to the “knockout” clauses in the Fed’s forward guidance, which states: “inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”, and are unlikely to be triggered.

For example, the MPC has never forecast CPI inflation above the 2.5% in 18-24 months “knockout” threshold in the past, despite extremely high headline inflation and we may expect that it is unlikely the MPC will choose to do so under a regime of forward guidance. The “knockout” on medium-term inflation expectations still allows the MPC plenty of room for interpretation and judgement (and its members discuss some aspects of this in the Inflation Report). But a substantial broad-based rise in inflation expectations across a broad range of business and consumer surveys, especially if accompanied by a sharp decline in sterling and rise in break-even inflation rates in fixed income markets, would likely be sufficient to prompt a “knockout”. Indeed, given the large and powerful pass-through to inflation from sterling’s depreciation in 2007-08, perhaps the biggest risk of a “knockout” comes from the currency – and that may well reduce the attractiveness of sterling as a funding currency.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla