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Wednesday, 10 July 2013

An argument for forward guidance in the UK

What is the Monetary Policy Committee (MPC) of the Bank of England (BoE) trying to achieve? I think there are two leading candidate answers.

1) Flexible inflation targeting, as understood by academics. This means trying to reduce both deviations of inflation from target, and the output gap, at all periods in time. Call this FIT for short.

2) Strict inflation forecast targeting (SIFT), or more specifically trying to minimise deviations of inflation from target in two years time. Under this policy, the outlook for the output gap in two years time is irrelevant.

In most circumstances FIT and SIFT will produce very similar interest rate decisions, because normally to achieve the inflation target within two years means aiming to eliminate the output gap by then too. However one time that the two objectives could give different decisions is if the economy is being hit by a persistent cost-push shock. Under FIT, that could lead in two years time to inflation being above target, and a negative output gap. Under SIFT, we might expect a tighter policy, trying to reduce inflation to target within two years, at the cost of a larger output gap. [1]

So which better describes MPC policy? The Bank of England publishes a forecast for inflation two years out, and the chart below shows this since independence. This is their forecast based on market expectations of interest rates: we unfortunately have no information about what MPC members expect future interest rates to be.

Bank of England forecasts for inflation two years ahead, by date of inflation report

The inflation target was 2.5% until 2004, but has been 2% since. You can see why many might think that SIFT is the policy. The financial crisis was such a big shock that the Bank did not think it could achieve this target for a year to two, but otherwise the two year ahead forecasts have been pretty close to target.

Unfortunately while this is consistent with SIFT, it could also be consistent with FIT. The Bank does not publish any estimates of the current output gap, let alone the expected output gap in two years time. In addition, the output gap before the recession was generally thought at the time to be fairly small, so it is quite possible that the inflation forecast above is also consistent with FIT. However, the last few years look much less like FIT than SIFT. Actual inflation has been above target, and we have a significant output gap, and this combination is at least partly down to some significant cost-push shocks (like increases in VAT). Yet expected inflation two years out is close to target. Can the Bank really be expecting the output gap to close in two years as well?

We have one additional piece of information, which are the Bank’s forecasts for GDP growth over the next two years. Even if the current output gap is large, if the Bank was forecasting growth well above potential in the next two years, it could be closing that gap in two years time i.e. doing FIT. As we get closer to the present, this looks less plausible. In particular, in 2012 the Bank’s growth forecasts were pretty low. Even if they were assuming growth in potential of just 1% p.a., that would imply that their estimate of the current output gap was between -1% and -1.5% if they expected to close the output gap in two years time. That seems implausibly low: the OBR has an estimate closer to -3%. I would therefore conclude that it is quite likely that the Bank has been pursuing SIFT, and not FIT. (The February 2013 inflation report is a possible exception.)

Why does this matter? With continuing cost-push shocks (such as an increase in student fees), SIFT is going to mean tighter policy than FIT. In addition, my own interpretation of the Treasury’s March 2013 review of the MPC’s remit is that they do not want SIFT, but instead favoured something closer to FIT.

Suppose I am wrong, and the MPC is pursuing FIT, but I am not alone in incorrectly thinking it is doing SIFT. Or alternatively, suppose it has been doing SIFT, but now - following the Treasury review and a new governor - it wants to do FIT. How can it clarify this? Well one possibility is just the kind of forward guidance that the Fed has given. If the MPC state that if - say - unemployment looks like remaining above 6% over the next two years, they would aim to have inflation significantly above 2% in two years time, then it becomes clear they are not doing SIFT.

So one argument for forward guidance is that it could avoid damaging ambiguity in what the MPC is trying to do. There are of course other arguments for and against forward guidance, and here I want to plug a new blog by ex-BoE, and now Bristol University, economist Tony Yates. His first post considers some of these issues, and his most recent post deals with the Treasury March review.

My own worry about forward guidance, which I expressed in the slides attached to this post, is that it is too incremental. I think a much clearer way of signalling the importance of the output gap is to adopt a path for nominal GDP as an intermediate target. I look forward to Tony’s future posts, which I suspect will include why he thinks this would be a bad idea!

[1] Two important caveats here. The first is obvious: if the output gap is given a trivial weight compared to inflation in the Bank’s objective, FIT morphs into SIFT. I have discussed why that is an unreasonable weighting here. Second, the optimal response to a cost-push shock if the central bank attempts to use future policy commitments to achieve the best outcome today will involve future periods in which inflation is below target, as I explain here. That would complicate discriminating between FIT and SIFT. However, as this policy is time inconsistent, the MPC would have to be quite open about this policy, and in the absence of such openness I think we can exclude that possibility.


  1. As far as I see it forward guidance is largely about market behaviour. Financial markets in particular.

    CBs have finally admitted implicitly that their QE stuff is blowing bubbles. And have started to realise that at the downside of things a move away from the present policies will lead to markets directly 'pricing in' that thing.
    Even worse the market simply seemed to work with the assumption that the FED would keep pumping liquidity int markets till 2357 (or something), different from anything the FED has ever stated or even suggested as a possibility.
    Leading to a sudden large drop (and the larger the bigger the bubble is) when policy changes are announced. Likely with margin effect as a lot of investments are done leveraged.

    They (mainly Mr Ben) try now to mitigate the effect of an exit (stepwise one). And not very successfully, eg timing is awful: trend heavily moving North but close to a reversal.
    When the FED started the rest had not much choice but to follow.

    Will be careful imho with increasing inflation targets. Last time Mr Ben announced something like that markets reacted strongly.
    Probably mainly on unemployment. Not even taking the Obama swap (changing one proper full time job for 2 minimum wage hamburger flipping ones) into consideration.

    Anyway forward guidance makes it possible to start pricing things in. Markets can do the risk estimate better and subsequently the calculation (when going more fundamental).

  2. Very nice post.

    Of the two "SIFT" is definitely closer. I think the MPC would claim to exercise discretion over the choice of horizon by which they attempt to bring inflation back to target - i.e. not always 2 years.

    And much is lost in saying "Bank did not think it could achieve this target": it is the fact that the CPI forecasts have been *above* target for much of the forecast period which has constrained policy - both for late 2008 and 2010 onwards.

    I ran a quick analysis and the Mean CPI forecast on a 3 year horizon has the smallest absolute deviation from 2% over the published data. (0.16% using a mean of the absolute forecast - 2%).

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