The Bank of England’s new governor, Mark Carney, has promised to keep interest rates at or below their current level - 0.5 per cent - until Britain’s unemployment rate - at present 7.8 per cent - drops to 7 per cent. For the central bank, this is a major change in how it operates monetary policy. First, the Bank has decided that the unemployment rate, rather than price stability, is for now its primary concern when setting monetary policy objectives. Second, the governor has introduced “forward guidance” on the bank’s policy intentions in order to manage the expectations of markets, businesses and consumers.
Mr Carney - previously a successful governor of Canada’s central bank - hopes a more open approach will reduce economic uncertainty, reassure financial markets and bolster a sluggish UK recovery. Certainly, the prospect of low interest rates for the medium term should encourage banks to lend, and give businesses more confidence to invest. It should also encourage consumers to spend more and force savers to save less.
If Mr Carney’s aims are fully met, interest rates will remain unchanged for three years. That assumes unemployment does not fall faster than anticipated, forcing a reassessment of monetary policy sooner. Forward guidance, whereby central banks sketch the broad direction of future policy can, however, be easily misinterpreted by financial markets. In the US, the Federal Reserve recently signalled its intention to slow asset purchases. But its guidance failed to reassure markets. Last month, the European Central Bank (ECB) for the first time embraced forward guidance by committing to keep key interest rates at present or lower levels for an extended time period. But, unlike the Bank of England, it will do so in the context of its primary objective - ensuring inflation rates stay close to 2 per cent over the medium term. The ECB’s mandate is price stability, not unemployment, which ensures it has much less flexibility than the Bank of England - and most other major central banks - now enjoy.