Bank of England's Mervyn King steals Carney’s thunder with focus on flexible inflation targeting
The Bank of England took a step closer in issuing explicit forward interest-rate guidance on Wednesday, a favoured call-to-arms of incoming governor Mark Carney.
Call it flexible inflation-targeting, flexible inflation-expectations targeting, a flexible central bank mandate, or expectations of a shift to a flexible central-bank mandate. Outgoing Bank of England (BoE) governor Mervyn King broke new ground on Wednesday in his penultimate press conference upon the publication of the BoE’s latest Inflation Report.
For the first time, the MPC publicly acknowledged that inflation is likely to remain above the central bank’s 2% target until end of 2015, rather than the typical two-year horizon in which the BoE was expected to bring inflation back to target. In other words, this could be seen as a conditional commitment to keep rates on hold for almost three years, unless inflation or inflation expectations overshoot dramatically, a prospect King said was unlikely given controlled waged-price inflation and the slack in the UK economy. The significance of the report lies in King’s explicit expectations-management game: a loose monetary stance will be adopted for longer than expected, with inflation overshooting target. This week, the MPC forecast inflation at 2.3% in two years’ time, the first time the central CPI projection has been above 2% since May 2008. Investec analysts said: “In earlier years, this would have provided a case for a tightening and the fact that the MPC has talked about the possibility of further easing demonstrates the extent that the MPC is already taking a flexible approach."
In its words: the MPC intends to “accommodate” the “temporary, albeit protracted” target overshoot to boost the real economy.
King, signalling his discomfort, referred to the guidance as covering a “multitude of sins”, which Barclays analysts said “suggests he would not be inclined to go further”.
As Investec analysts point out, King’s caveats about the potency of monetary policy to nurture growth were stark: “He explained that accommodative monetary policy encouraged households and companies to bring forward their spending. Over time therefore, policy would become less effective, offering the analogy that it was like running up an ‘ever steeper hill’ and that external demand and supply-side improvements were necessary to encourage expectations of a higher path of income, which would result in firmer spending.”
In a note titled Tired of Climbing the Monetary Hill, Barclays analysts added: “[King] was concerned that monetary expansion was having a more pronounced effect on asset prices than it was on the real economy, and that the disconnection between the two might not be fully appreciated by investors.”
The market might no doubt be sceptical that this rate-guidance amounts to nothing new in practice, since the inflation target has overshot 2% some 90% of the time during the past five years. In other words, the MPC has already exercised flexibility.
Nevertheless, the MPC’s public announcement of low rates for longer than expected – even after stating inflation will overshoot target – reeks of incoming BoE governor’s preference for forward-rate guidance, and is qualitatively different than the former policy of benign neglect over the inflation target and constructive ambiguity over the time-horizon in which the BoE will seek to return prices back to the 2% range.
How the UK monetary regime might become more flexible is the rub. Carney sounded bullish about the potency of further monetary stimulus in his testimony to UK parliamentarians last week. One of his first jobs will be to write a letter to the UK chancellor about why inflation is higher than mandated. King has clearly made Carney’s task of convincing his fellow MPC members of the virtues of further stimulus easier.