When central bankers communicate their intentions for monetary policy they need to combine clarity with credibility. By making it clear what the triggers are for policy to change, the central bank can leave itself having to do less — market interest rates will have already adjusted in anticipation of the central bank’s moves. For such guidance to work, however, investors must both know exactly what the central bank intends and believe that, when push comes to shove, it will do it. At its meeting last week, the Bank of England set out guidance that managed to do both.
A faster than anticipated increase in inflation as the economy reopens after coronavirus restrictions has led to the central bank ending its previous guidance that it would not raise rates until its 2 per cent target was reached “sustainably”. While the BoE expects the current surge in price growth to dissipate as the economy reopens, it will still face the challenge of a labour market transformed by both the pandemic and Brexit.
The central bank’s policy was unchanged: its lending rate was kept at a record low of 0.25 per cent and the BoE maintained its target for the total stock of asset purchases. The meeting was nevertheless significant — both for the changes to its inflation forecast and for setting out a framework for how it would unwind its quantitative easing programme. With this combination, the central bank is helping to reassure investors and economists who have fretted that the BoE has taken its eyes off the ball with regard to inflation.
The bank revised up its forecast for inflation this year, predicting it will peak at about 4 per cent, but said it expects this to be transitory. Inflation is forecast to fall back to 1.9 per cent by 2023, slightly below its 2 per cent target. Conditioning its predictions on current market interest rates, this suggests investors and the central bank agree on the need for only a modest increase in rates over the next couple of years.
The central bank also struck a more hawkish tone by setting out how it will engage in “quantitative tightening” when it shrinks its portfolio of assets. The trigger is for its policy rate to reach 0.5 per cent. At that point, the BoE will stop reinvesting bonds that mature. After it raises rates to 1 per cent it will then start selling the bonds as well. This reaffirmed that interest rates will remain the main policy tool.
Critically, the guidance also gives the central bank room to reverse its strategy if its forecasts prove wide of the mark. Forecasts of what happens to inflation and wages as the pandemic comes to an end can only be best guesses. Only guidance that includes the possibility of adjusting in response to the data can be credible.
The BoE faces an even more uncertain outlook than its peers overseas. In the UK the changes to the jobs market provoked by the pandemic are combined with the country’s departure from the EU and new restrictions on migration. It is so far unclear which labour shortages — or what the central bank referred to as frictions — are a transitory consequence of reopening, and which are reflective of more structural change in the economy.
The central bank’s rate-setting committee has indicated that it will be closely watching to see if increases in labour coststurn out to be temporary, or something more permanent that eventually feeds through into inflation. This, rather than the progress of inflation over the next year, will dictate the pace of any monetary tightening. Investors who want to anticipate what the BoE will do next now know what to look out for.