Interest rates won't rise until unemployment falls below 7%

Mark Carney has chosen to peg 'forward guidance' on the base rate to unemployment. It's risky - but then, he's not afraid of a bit of risk.

by Emma Haslett
Last Updated: 28 Aug 2013

Well. The international money markets seem to like Bank of England governor Mark Carney’s forward guidance wheeze. The initial reaction may have been a drop in Sterling against the US Dollar – but the pound has now edged to a six-week high. To wit:

Bearing in mind that Carney’s press conference began at 10.30, we’d say the markets were feeling pretty skittish…

Carney’s much-anticipated forward guidance is all very ‘Bank of the People’: it’s designed to help investors and households with their day-to-day decision-making by giving an indication of whether the interest rate is likely to rise over the next few years.

There had been debate around what he would peg his decision-making to: some suggested he would issue guidance saying base rates wouldn’t go up until the ‘output gap’ – the amount of slack there is in the economy – closes, while others suggested pegging it against inflation or GDP growth would be more prudent.

In the event, Carney chose unemployment, saying the rates won’t rise from 0.5% (where they’ve been for the past 51 months) until unemployment falls below 7%, on three conditions: that low interest rates don't post a threat to financial stability, that they don't increase medium-term inflation expectations and that they don't affect the Bank's forecast that inflation will fall below 2.5% in 18 to 24 months' time.

At the moment, unemployment is 7.8%: looking at forecasts, we’ve got about three years to go before those mortgage payments start to go up.

It's an intriguing choice: unemployment is easy to communicate with the public, and the employment figure has been pretty robust during the course of the downturn (at least, compared with our European neighbours), so it isn’t a measure that will crumble easily, should there be a blip in the recovery.

‘But it’s still dodgy’, chorused a volley of economists as Carney made his announcement. Firstly, there will always be a ‘natural’ unemployment rate of about 5.4% of people who are unemployable for various reasons – from disabilities to bad luck to, as the tabloids are fond of saying, sheer laziness.

Secondly, unemployment isn't always a great guide to what's going on in the economy. As we've seen with the debate over zero-hours contracts and part-time work, there are thousands of people in the UK who aren't working at 'full capacity'. So there's a lot of hidden unemploment. And once unemployment begins to gather pace, that's an indication things are going wrong - whether or not it's hit that 7% threshold.

There's also the argument that it’s another way of saying the same thing: after all, the Monetary Policy Committee, the body in charge of deciding on the base rate, have said all along that they won’t raise rates until the economy is in a stronger state. Unemployment is a bellwether of that, so pegging guidance to that is also saying ‘we’ll raise rates when things improve’.

But if there’s one thing Carney has demonstrated in the month since he took the reins at the Bank of England, it’s that he is not afraid of a bit of risk. Having recruited one of his old mates as his deputy, he has eased pressure on some banks to meet new regulatory requirements, published documentation showing the part the Bank played in helping Nazis loot gold and reversed the decision to erase women from banknotes. So at least he has the courage of his convictions. Even if others don’t.

The primary goal is supposed to be keeping inflation at 2%, and it's now been above 2% since November 2009. So Carney's shift of focus to forward guidance is an acceptance that inflation is unlikely to hit its 2% target for a long time to come.

Find this article useful?

Get more great articles like this in your inbox every lunchtime