Mark Carney will not take up his position as governor of the Bank of England until July 1 2013, but in the interim he will be speaking frequently about monetary policy in his current role as governor of the Bank of Canada. It is inevitable that his words will now be judged in a new light, especially when he makes generic comments about monetary policy, rather than specific remarks confined to the Canadian situation.
This is why his speech on “guidance” on Tuesday was so interesting. Although he stated that this speech did not contain any direct signals about policy in Canada or anywhere else, it did give clear indications about his general thinking on the future of unconventional monetary easing. To add, his thinking appears to be different in several important respects from that of the Bank of England’s current governor and the monetary policy committee. Mr Carney is not exactly naive, and he must surely have realised his words would be interpreted in this way.
The Carney philosophy on the next steps on unconventional monetary easing is more Ben Bernanke than Mervyn King in flavour, though it goes even further than the Fed chairman in embracing nominal GDP level targets if circumstances warrant it. There are three areas where Mr Carney’s thinking might unsettle the current orthodoxy at Threadneedle Street, all of them in a more dovish direction.
1. The inflation target
Mr Carney has always been a strong supporter of “flexible” inflation targeting in normal circumstances, and in that respect he does not differ at all from the approach pioneered by Mervyn King. However, he does seem to interpret the scope for flexibility more widely than his new colleagues at the BoE. In his speech, he says that after an economic shock, the central bank should be able to vary the time it takes to return inflation to target from two quarters on the low end to 11 quarters on the high end, taking “due consideration of the consequences for volatility in output and financial markets”.
Up to now, the BoE has used much less flexibility than this, almost always trying to return inflation to target over about six-eight quarters. (Of course, they have usually missed this target in recent times, but not deliberately so. ) This difference could allow the BoE in future to bring inflation back to target more slowly after a commodity price or VAT shock to the price level, in which case the average rate of inflation over time would tend to be higher than under the current regime.
2. Forward policy guidance
The current BoE line on forward guidance is largely hostile, on the grounds that the central bank cannot possibly know what it is likely to want to do in future, and should not pretend to do so. Mr Carney, by contrast, has always been a strong proponent of using forward guidance to ease monetary conditions when interest rates are at the zero lower bound, and has done this in Canada in 2009-2010. On Tuesday, he said:
A central bank may need to commit credibly to maintaining highly accommodative policy even after the economy and, potentially, inflation picks up. Market participants may doubt the willingness of an inflation-targeting central bank to respect this commitment if inflation goes temporarily above target. These doubts… delay the recovery.
This could mean that a Carney-led BoE could issue an unemployment target, subject to some form of inflation ceiling (such as the Fed on Wednesday), or a commitment to keep interest rates close to zero for a prolonged period. Forward markets already show the policy rate remaining at below 0.5 per cent until the beginning of 2015, so the scope for forward guidance to impact expectations is limited, but it is not zero. For example, a commitment to keep rates at close to zero until the start of 2016 would probably reduce the five-year bond yield by about 20 basis points.
3. A nominal GDP level target
If none of the above proved sufficient, Mr Carney suggests that “the policy framework itself would likely need to be changed” (presumably, in a UK context, by the Treasury rather than the BoE). As an example, he suggests a nominal GDP level target where “bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP”. He shows the following chart to explain how this would work:
The underpinning of this chart is that the nominal GDP level target (NGDP) would commit the central bank to allow a period in which inflation exceeds the 2 per cent target to eliminate the NGDP gap. As I have argued before in this blog, the problem with this arrangement is that the growth of potential GDP may have slowed down since 2007, so any attempt to hit the previous trend for NGDP will simply cause inflation to exceed its 2 per cent target until the BoE is forced to abandon its strategy.
In a speech on “sticky inflation”, the BoE’s chief economist, Spencer Dale, points out that inflation has been stubbornly above target since 2008 because there have been real shocks to the economy, especially a negative shock to productivity growth. He says that, in order to have hit the 2 per cent inflation target, the MPC would have had to impose an even deeper recession on the domestic economy. The implication, of course, is that the growth rate of potential output has fallen far below the level suggested by extrapolating long-term growth rates forwards from 2007. It is hard to square this point of view with the idea that NGDP can return to its long-term trend without raising inflation permanently, which is what Mr Carney’s graph clearly seems to imply.
It would be unfair to Mark Carney to claim that he has formally made any commitments about what he may want to do when he is in charge of the UK MPC. He has not done that. And in any case he will be only one of nine voters on the committee. But has laid out a monetary manifesto that is more dovish than the received wisdom at the BoE. The markets will be watching carefully to see whether he backtracks from the impressions he has now given.