Bank’s forward guidance policy has backfired, claims economist

Andrew Sentance, who was a member of the rate-setting MPC between 2006 and 2011, said that the new Governor Mark Carney’s flagship policy had given an unrealistic view that interest rates would stay low for a long time. He said the Bank should be preparing the ground for a gradual rise in interest rates.

Mr Sentance, who is now senior economic adviser to professional services firm PwC, made the comments during a visit to Leeds.

Last week, a Reuters poll reported that 28 out of 56 economists said that the Bank had lost credibility over its forward guidance framework.

Central banks in various economies use “forward guidance” – advance notice that monetary conditions will not be tightened too fast or too soon – as a way of managing market bets, at a time when the scope for stimulating economies through conventional interest rate cuts was limited.

When it was first introduced by the Bank in August, the policy’s attempt to dampen expectations of interest rate hikes had the opposite effect. Investors brought forward their bets on rate increases. At the time, the Bank promised to keep rates at a record low at least until unemployment fell to seven per cent, something it forecast would take more than three years.

But in November, the Bank forecast that unemployment could hit seven per cent as early as the end of this year. It also stressed that higher rates would hinge on other factors, such as labour market productivity.

Mr Carney, the Bank’s governor, recently urged against “unnecessarily focusing too much on just one indicator” and indicated the Bank was in no hurry to raise interest rates.

Mr Sentance said: “I think forward guidance has actually backfired for the MPC because when it was announced in August, the governor presented the view that this would create a long period of low stable interest rates. I always thought that was unrealistic.

“What’s happened is the economy has picked up more quickly. We do seem to be moving into an environment where rising interest rates would be more appropriate.

“Now the important thing is not to alarm people, and to ensure that that rise in interest rates is gradual. That’s the most important element of forward guidance, not to try and persuade people that interest rates can stay at 0.5 per cent forever, because I don’t think that’s very realistic, but to prepare the ground for a gradual rise in interest rates rather than a sharp hike.

“I spent most of my career in the business world. The economy can adjust to things that people can look forward to and plan for. So what the Bank of England needs to do is prepare the ground for the notion that interest rates will be gradually rising...We set that interest rate in very difficult circumstances in 2009 and now the economy is recovering. So rather than try and persuade the public and businesses that we can keep that slightly unrealistic position for too long, the bank should be preparing the ground for a gradually rising interest rate.

“Forward guidance, as it was set out in August last year was flawed. But I think the idea of forward guidance can be useful, if it’s conditioned around this idea of preparing the ground for something that needs to happen, which is a gradually rising interest rate.

“In the depths of the financial crisis, I don’t think there was too much disagreement (in the MPC) about what needed to be done. We could see that the economy was under some significant threats.

“Where there has been more disagreement, and where I would take issue with the MPC, is trying to find the way out of those policies, because they are not really sustainable for the economy over the longer term.

“An interest rate of 0.5 per cent doesn’t strike the right balance between savers and borrowers. There are more savers than borrowers actually in the UK economy. If you keep interest rates too low for too long you’re not providing the right incentives for savers.

“Secondly, the Bank of England has now accumulated £375bn of Government bonds which will need to be sold back into the market at some time. That’s another policy that we need to plan the exit from. The best way we can exit from these very unusual policies is gradually.”

The Bank declined to comment about Mr Sentance’s remarks.

The minutes of the latest MPC meeting said that the members concluded that “when the time did come to raise Bank rate, it would be appropriate to do so only gradually”.

The MPC did not see “any immediate need to raise Bank rate”.