The Bank of England appears to have moved the goalposts. After 30 years of focusing almost exclusively on inflation, monetary policy is now being more explicitly directed toward generating faster growth and lower unemployment.
Earlier this year, the need to stimulate the British economy was articulated by Chancellor George Osborne, when he told the Bank of England to be more flexible with its inflation target and to think carefully about the trade-off between combating inflation and the impact on the real economy. The Chancellor made it very clear that the Bank would be held accountable for this judgement.
Mark Carney seems to be taking this advice seriously. The new governor recently said that the Monetary Policy Committee would weigh the “potential trade-offs” between growth and inflation as part of its decision on when to raise interest rates. He pointed out that: “Such policy trade-offs will inform future MPC decisions on the timing of any Bank Rate increase after the threshold is reached,” referring to the 7.0% unemployment rate which underpins the Bank’s forward guidance.
The Bank expects UK GDP growth to be “materially stronger,” if rates remain unchanged and expects this trend to continue in 2015 and 2016. Without a rate change, the BoE calculates 3.4% growth in 2014 vs. 2.9% if rates were to rise in line with market expectations.
But what is the price for this extra growth? By the fourth quarter of 2016, the end of the forecast horizon, the Bank expects inflation to be 2.14% if it leaves rates unchanged and 1.95% if rates rise in line with market expectations. So the Bank’s best collective judgement of the current trade-off between inflation and growth shows that the price of materially stronger growth and lower unemployment over the next three years is a small overshoot of the inflation target at the three-year forecast horizon. In fact, Carney did not even describe this as an overshoot—he called it “close to target”.
There will, of course, be a range of views on the merits of this trade-off within the MPC. But the very fact that the Bank is willing to have this debate suggests that the government’s message is getting through and that something important has changed since Carney came on board. As a result, the Bank’s message appears dovish, and monetary policy seems likely to remain highly accommodative – even if growth remains strong.
Given the generally poor performance of the UK economy since the 2008/09 recession, this renewed focus on growth and employment might be seen as a welcome development. But those with memories of 30 years or more ago will remember that the last time policymakers thought there was a workable trade-off between growth and price stability, the inflation surge that followed took a very painful dose of monetary medicine to defeat.
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Darren Williams is Senior European Economist at AllianceBernstein.