An Introduction to Forward Guidence

Henry Allen

The new Governor of the Bank of England, Mark Carney, has already made his mark on the institution. A radical change in the conduct of monetary policy, with the introduction of forward guidance has been introduced this summer. Such a policy is where the central bank indicates publicly its intentions of the future path of interest rates, which may be tied to a time-frame, or to other economic variables.

Forward guidance has been just one of the many radical monetary policy changes in recent years. These include inflation targeting, press conferences and the more recent use of unconventional tools such as Quantitative Easing in order to stimulate economic growth. The introduction of forward guidance has been used by Carney in his previous job as Governor of the Bank of Canada, where he promised in April 2009 to hold the interest rate at 0.25% until the second quarter of 2010, although contingent on stable inflation.

The introduction of forward guidance to the UK was first raised at the time of the budget in March. George Osborne, whilst announcing a review of the monetary policy framework said that “the [Monetary Policy] Committee may wish to issue explicit forward guidance, including using intermediate thresholds in order to influence expectations on the future path of interest rates.” Governor Carney reported back in August’s inflation report, where he announced in his press conference that “The MPC intends, at a minimum, to maintain the currently exceptionally accommodative stance of monetary policy until economic slack has been substantially reduced, provided that this does not put at risk either price stability or financial stability.”

In terms of actual monetary policy, Carney stated that the MPC would not raise the base rate above its current 0.5% until unemployment (currently 7.7%) falls to 7%, subject to inflation not running above target into the future, expectations of future inflation becoming unanchored, or risks to financial stability from such a policy. The 7% is a threshold however, not a trigger, so in the event of unemployment falling to 7% that would not necessarily entail a rise in interest rates. In the inflation report, the Bank forecast the unemployment would not fall to such a level until mid-2016 (see right).

Source: Bank of England, Inflation Report, August 2013Unemployment BoE IR Aug 2013

The aim of the policy is to entrench interest rate expectations into the future, and thus encourage extra spending that will serve to stimulate the economy. However, with the surprising turnaround of recent economic data, markets are sceptical of Carney’s pledge that interest rates will hold low until 2016 – especially as positive economic data would also mean the unemployment threshold of 7% is reached within a quicker timeframe. The Bank of England now faces the task of managing interest rate expectations into the future, with forward guidance as a policy instrument on the table for the foreseeable future.

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