Why governor’s monetary revolution will eventually backfire

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ONCE again, I find myself in a minority. Most economists – and the overwhelming majority of commentators – are delighted with Mark Carney’s shake-up of monetary policy. But while I welcome the governor’s enthusiasm, I am unconvinced by his proposals.

First, the theory. Carney’s thinking is that 1) there is plenty of spare capacity in the economy 2) keeping rates low (and possibly doing more QE) will boost demand 3) this will translate into increased output and jobs, not increased inflation 4) the unemployment rate is a decent, easy to measure proxy for spare capacity 5) providing long-term guidance will push down long-term rates, improve visibility, further boost demand and GDP growth, avoiding Fed-style uncertainty over tapering and tightening 6) but that some of these assumptions could change and low rates could have other, negative side-effects, thus requiring a change of policy. I have issues with 1), 3), 4) and the market didn’t buy 5).

I don’t think there is much spare capacity that would be put to use even if demand were to be buoyant, especially in our open economy. Much capital – human and physical – isn’t lying idle but has been destroyed. There is a mismatch between people and jobs. The lost output and potential growth is gone forever. The supply-side of the economy will be unable to respond to the level of demand we will see over the next few years, fuelling imports and pushing up consumer and asset prices. Unemployment is not a great measure of spare capacity; over time, employment is determined by supply-side factors. The official statistics don’t adjust for hours worked, among other issues. The Bank thinks that by 2016 GDP will have grown strongly, rates will still be at emergency levels and that inflation will be falling to two per cent. That’s implausible. Interest rates should actually already be going up.

Second, the practice. The MPC intends not to raise rates at least until the Labour Force Survey measure of unemployment has fallen to seven per cent, requiring 750,000 net new jobs, a development it expects by 2016 – as long as three “knockouts” aren’t triggered, namely a) that in the MPC’s view, it is more likely than not that inflation 18-24 months ahead will be 2.5 per cent or higher; b) that medium-term inflation expectations no longer remain sufficiently well anchored; and c) the Financial Policy Committee (FPC) judges that monetary policy poses a significant threat to financial stability that cannot be contained by policies available to the FPC, the Financial Conduct Authority and the Prudential Regulation Authority.

So the Bank wants firms and consumers to plan for rates staying on hold for three years – but taken at face value, the overall pledge is incredibly loose: anything is possible. The supposed certainty that forward guidance was meant to introduce comes with more caveats than gruyere cheese has holes. But I doubt c) will happen. As to a), the Bank will continue to under-predict and tolerate high inflation. Inflation has been 2.5 per cent or higher in every month since December 2009 except for June 2012, September 2012 and April 2013, so if the Bank had predicted inflation correctly, its new knockout would have meant rate rises in all but three months. In reality, a CityAM analysis confirms the knockout would not have been triggered at any time since at least 2004 because the Bank’s forecasting has been so hopelessly dovish. Only b) could derail Carney’s guidance: if inflation rockets, markets panic, wages shoot up and the MPC rebels.

Expect strongish growth, persistent inflation, a worsening current account deficit and a housing and gilts bubble that eventually ends in tears and a severe rate hike in 3-4 years. That’s no different to what we would have had under the old regime; the new rules merely turn a de facto policy into a de jure one. Great for George Osborne’s 2015 election prospects, sure, but not a sustainable way forward for the UK.

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