In March, chancellor George Osborne invited the Bank to adopt new monetary policy tools to stimulate growth, and speculation has since ensued about which measure the new governor would opt for.
At the Bank of Canada, Mr Carney was one of the first central bankers to use "forward guidance" in a bid to instill consumer and business confidence. Previously, central bankers spoke with an almost Zen-like restraint about future policy direction.
Since Mr Carney used forward guidance successfully in Canada in 2009 to 2010, it has been adopted by the US Federal Reserve and the Bank of Japan. Like the Fed, the Bank has chosen to adopt dual forward guidance on inflation and unemployment. Mr Carney signalled that the Bank will not consider raising interest rates from their record low of 0.5 per cent until the unemployment rate falls to 7 per cent. Currently, it is 7.8 per cent, and Bank forecasts indicate that the target will not be reached until 2016, implying three more years of low rates.
Of the various forms of forward guidance, such as committing to low rates for a specified period or using a growth-related target, Mr Carney has opted for unemployment, as the data is monthly and reliable. A time-based commitment would have been the wrong approach now, and GDP growth data is less appropriate, as it is backward-looking and prone to revisions.
Mr Carney’s big announcement was not as well received as he would have wished, however. The stock market fell over 1 per cent and sterling strengthened, suggesting that investors are unconvinced by his guidance. This is because of the three caveats that Mr Carney also outlined: the Bank will only leave rates unchanged if any of its three "knock-out" conditions are not breached.
The Bank will consider raising rates if: one, its CPI inflation forecasts for the next 18 to 24 months exceed 2.5 per cent; two, there is a general expectation of inflation in the medium-term; or three, the BoE’s financial policy committee believes there is a risk of financial instability, such as a bubble in the housing market.
In reality, all three of these represent a distinct risk, particularly as the Bank also confirmed the economic recovery by revising its growth forecasts: GDP has been increased from 1.2 to 1.4 per cent for this year and from 1.7 to 2.5 per cent for 2014.
However, Mr Carney’s 2016 vision of strong economic growth, supported by ultra-low interest rates but without inflation, looks very optimistic, particularly given that the Government’s Help to Buy scheme is stoking up a housing market bubble.
With the economy returning to meaningful growth, a prudent Bank might contemplate a rise in interest rates as early as 2014. Meanwhile, there is a real risk of inflation taking hold. Since December 2009, CPI inflation has been at or above the 2.5 per cent knock-out level every month, apart from three.
Were sterling to weaken against the dollar, which is quite possible given that US interest rates are now likely to rise before UK rates, inflation would be pushed up by higher food and oil import prices. And, with a recovering economy, workers may start to feel more confident in asking for wage increases, particularly as real wages have been falling for over three years. This also increases the risk of inflation.
All things considered, we appear to be heading towards a period of higher inflation, which could be exacerbated by a policy-fuelled housing boom. Indeed, if the man on the street already feels that inflation is higher than stated figures, it probably is.
In these circumstances, interest rates would normally be increased before the end of 2014; however, with an election in May 2015, and a Bank governor that some argue created a housing bubble in his native Canada, it is more likely that there will be a hard landing in 2015/16, as the Bank tries to shut the stable door after inflation has bolted.
Mr Osborne will surely be delighted with Mr Carney’s approach as it suggests the economy could grow – albeit unchecked – well past the general election in 2015. But the tension between what should happen and what will happen is likely to increase market volatility around economic data releases over the next two years. Ironically, such disruptive uncertainty would be the very opposite of what forward guidance is intended to achieve.
The guidance might be a welcome commitment to communicate, but there are no guarantees.
Julian Chillingworth is chief investment officer at Rathbones, as well as manager of the five crown-rated Rathbone Blue Chip Income & Growth fund.
Performance of fund, sector and index over 3yrs
Source: FE Analytics
The fund has beaten its sector average and FTSE All Share benchmark over one, three, five and 10 years.
