Carney signals change to interest rate and inflation policy

Carney signals change to interest rate and inflation policy

Mark Carney, incoming Bank of England Governor, says the central bank could provide guidance on the future path for interest rates - a move that would help reduce uncertainty for those planning to buy a home or invest in a business.

Economic Analysis

07 February 2013

Speaking to the Treasury Select Committee (TSC), Carney, governor of the Bank of Canada, said interest rate guidance was not helpful during normal economic conditions.  But he added that when the Bank of Canada felt interest rates had got as low as they could go, other measures had to be considered. 

“We felt we could use communication to provide the extra stimulus. It sent a message there was going to be stimulus for a set amount of time, so that people could plan and put in place if they were going to buy a house or renovate. They had time to act on this. Everybody knew about this commitment in Canada. And it had an effect,” he said.

The monetary policy committee has voted to keep the UK’s base rate at 0.5% for four years, and has used quantitative easing to boost the economy. But the policy has been blamed for having a detrimental effect on pension funds by reducing bond yields and lowering pension annuity rates. Carney said he was looking forward to contributing to the TSC’s review of QE, adding: “There are distributional consequences of QE. All monetary policy has distributional consequences.”

James McCann, economic adviser for RBS Group Economics, believes the Bank of England could start to provide guidance on future interest rates as soon as the second half of 2013. “Carney wants a full review of the UK monetary policy framework within six months. While he would need to build consensus on the Monetary Policy Committee, we would not be surprised to see the Bank provide guidance on future interest rates by the end of this year or in the first half of next,” he said.

He added that RBS Economics expect the base rate to remain at 0.5% until the end of 2016.

Carney told MPs he is also willing to be flexible about inflation, allowing for higher levels should the economy slump further. He described flexible inflation targeting - where the rate of inflation is allowed to move above and below the desired level - as the most successful monetary framework in existence. But he added that the key issue was the time period over which inflation must return to the target - normally between six and eight quarters, or 1.5 to two years. But the CPI rate of inflation, the government's preferred measure, has not been as low as 2% since 2009.

Carney has previously suggested banks might need to ditch inflation targeting altogether and switch to a nominal GDP (NGDP) targets instead. This is a broader framework for monetary policy that takes economic growth as well as inflation into account. The proportions of these can vary widely: an NGDP target of 5% could comprise 2% inflation and 3% growth, or 5% inflation and 0% growth.  If growth is weak, inflation must be higher to make up for the shortfall, implying a more aggressive monetary policy such as rates on hold for longer or more QE. 

It also means that inflation can be harder to predict for businesses and consumers.

Carney was cautious about this policy in his live testimony, and in written evidence submitted to the Committee, he said he had not yet "made an assessment of the merits of altering the monetary policy framework in the UK".

However, Canada reviews its targets every five years and Carney suggested that periodic reviews in the UK would be useful given the "current extraordinary circumstances".

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