Where financial markets are effective in eliminating arbitrage opportunities, medium-to-longer-term borrowing rates are determined by evolving expectations about macroeconomic policy-determined short-term rates. Here, agents make two judgements. The first relates to the strategy that directs a monetary authority’s decisions on short-term interest rates. The second relates to the monetary authority’s anticipation of future information relevant to its decisions. Mark Carney’s ‘forward guidance’ is an attempt to influence that second judgement.
The standard strategy for setting short-term rates became stylised as the Taylor Rule, whereby two sets of deviations (from an inflation target and from an economic growth trend) determine the official short-term rate. As the latter has already been set close to zero and as growth is slower than the UK authorities would have it, an alternative ploy has been used. Quantitative easing (QE – the central bank purchase of sovereign debt) reduced medium-to-longer-term rates still further, but with the risk of stirring inflation. That risk is currently held in abeyance by the general understanding that QE will be reversed – an understanding that is threatened by forward guidance.
But, although denoted by some as the Carney Rule, forward guidance lacks the clarity of a rule: ‘until the margin of slack within the economy has narrowed significantly, it will be appropriate to maintain the current exceptionally stimulative stance of monetary policy, provided that such an approach remains consistent with […the…] primary objective of price stability and does not endanger financial stability.’
The nub: both the near-zero official short-term rate and QE at £375 billion are to remain unchanged until unemployment falls below 7 per cent (officially expected around mid-2016); but this is conditional upon the inflation forecast for the medium (18/24 month) term remaining below 2.5 per cent and financial stability not being threatened.
Just as Hamlet criticised the player who ‘out-Herods Herod’, so Mark Carney might be charged that he ‘out-Keynes Keynes’. First there was ‘pump-priming’, then came ‘kick-starting’ and now Mark Carney insists on reaching ‘escape velocity’. Yet, the information content of his pronouncements is nil: market expectations of a rise in short-term rates by mid-2015 are unchanged. The purring noises of approval from No. 11 imply, however, that George Osborne senses a pre-election ‘feel-good factor’ in the making.
It is all so horribly familiar.