Carney's straitjacket

Well, that was certainly unexpected!  Bank of England Governor Mark Carney introduced his much-awaited "forward guidance" framework for interest rates today, and basically made the unemployment rate the primary determinant of policy.  Carney effectively committed the Bank to keeping interest rates at rock bottom levels until unemployment falls below 7 percent.

The UK's current official unemployment rate is 7.8 percent.  Given the continuing relatively sluggish recovery in the economy -- which is still smaller than it was before the financial crisis hit -- Carney's commitment has convinced most commentators that official rates will stay low until at least 2016.  It could even be longer if productivity starts to rise as the recovery picks up steam.

The Bank's new approach is not unique.  The US Federal Reserve has always had a twin mandate of preserving the value of the currency and keeping the economy strong. In recent months, Chairman Ben Bernanke has repeatedly stressed that the Fed will only start to tighten its policy settings (initially by "tapering" quantitative easing) when US unemployment falls to a more acceptable level: the figure normally cited, as in the UK, is 7 percent.

Like the US, the UK has its own QE program in place, and as in the US, the first stage in withdrawing monetary stimulus was always likely to be a reduction in the scale of that program.  Since that will have to be done with great caution in order to avoid spooking the markets, it has always been clear that actual increases in rates are some way ahead.

From that perspective, Carney's commitment today may not be as much of a sea-change as some are suggesting.  However, it is surprising to find a banker as canny as Carney tying his own hands in this way, particularly when,  as many of the readers commenting on the linked article have noted, the unemployment rate is such a flawed measure of the state of the labour market. Interestingly, Chancellor George Osborne has welcomed Carney's announcement, even though he and most of his predecessors have generally preferred to focus on the alternative "claimant count" measure of joblessness.  Unsurprisingly, the claimant count numbers normally make the government of the day look better than the unemployment rate does.

It's possible that Carney has sown the seeds for future problems here.  He has made it clear that the Bank reserves the right to start raising rates with unemployment above 7 percent, if it concludes that the pace of GDP growth is responsible for pushing inflation above 2.5%.  This opens up a whole new field of speculation for bank watchers: "inflation is pushing higher, but does Carney think that's because of GDP growth or is it a result of one-off factors?"   Conversely, what if unemployment falls to 7 percent but measured inflation remains below target?  Will Carney feel obliged to raise rates in order to maintain credibility?

Canada's National Post has rather cruelly reported that Carney has "befuddled" Britain with today's announcement.  That seems unduly harsh, but it will be some considerable time to discover whether today's choice of "the road less taken" is too clever by half.

UPDATE, 9 August:  Looks as if Jeremy Warner at the Telegraph agrees with me.