New 7% unemployment threshold indicates current monetary policy stance will remain until Q3 2016.
After assessing the various options the Bank of England concluded that forward guidance based on some intermediary threshold can enhance the effectiveness of monetary policy for three reasons. (1) It will provide greater clarity on the trade-off between inflation and growth, (2) it reduces uncertainty about the future path of monetary policy and (3) it explores the sustainable level of employment and output without putting price stability at risk.
Forward guidance: MPC intends not to raise Bank Rate above its current level of 0.5%, at least until the Labour Force Survey headline measure of unemployment has fallen to a threshold of 7%, while not putting price stability or financial stability at risk.
According to the BOE forecast included in the Inflation Report, that is more likely than not (above 50% probability) to happen in Q3 2016. Hence, the bank rate will remain at current level at least until second half of 2016 and nor does the BOE intend to reduce the stock of asset purchases.
However the unemployment threshold setting has three knockout conditions:
1) It is more likely than not (above 50% probability) that CPI inflation 18-24 months ahead will be above 2.5%.
2) Medium-term inflation expectations no longer remains sufficiently well anchored.
3) The stance of monetary policy poses a threat to financial stability.
To summarize the BOE forward guidance therefore includes:
1) A threshold related to the slack in economy (unemployment).
2) An explicit date when this threshold is expected to be reached (currently Q3 2016).
3) Conditions for when the threshold could cease to hold (knockouts).
Growth forecast: As we suspected based on data since the May inflation report the outlook for growth is revised higher compared to May, as recent data has been stronger than expected, including strong improvements in business and consumer sentiment. Moreover the BOE judges the new forward guidance will make monetary policy stimulus more effective going forward. The BOE expects GDP growth at 1.5% (prev. 1.2%) in 2013 and 2.7% (prev. 1.9%) in 2014.
CPI Inflation forecast: Inflation is likely to stay around 3% in near term but is thereafter projected to fall back to around the 2% target by mid-2015. The committee’s best collective judgment is moreover that the probability that inflation is at or above the 2.5% knockout level in 18-24 months time is less than 50% (around 40%).
Monetary policy implications: The new threshold related to unemployment for when to reconsider current monetary policy stance indicates the BOE is likely to hold the bank rate at current low rate for longer than expected and is in that sense a dovish signal. On the other hand the unemployment threshold was combined with knockout conditions, which probably was not expected by the market and therefore somewhat disappointing. In addition the BOE told the new forward guidance does not mean the MPC is promising to keep interest rates low for a particular period of time. With stronger growth going forward and without a pick-up in productivity growth the current threshold value for unemployment could well be reached prior to the BOE forecast. Moreover the BOE has notoriously failed to predict inflation, which has stayed above the 2.5% knockout level for 51 out of the last 63 months. Hence, although the probability is judged to be below 50% that inflation will be above the knockout level, the probability based on history seems a lot higher. If growth continues to improve in line with the BOE forecast the probability for further QE also appears to be very low.
FX implications: The new forward guidance for sure had dovish implications, which should have been GBP-negative. However, after members previously voting for further QE had changed their dovish stance, expectations on today’s news from the BOE mounted. Although the BOE delivered in line with reasonable expectations it was not enough to please the market and the knockout conditions included were probably a surprise. Moreover, strong UK data in recent weeks have not been fully priced in to the GBP due to today’s report. However, stronger growth and the risk that some of the knockout conditions might be triggered made the signals less dovish than feared. From a long-term perspective the GBP is around its fair value against the euro and the dollar. With inflation above levels of trading partners and low productivity growth it appears the only way to compensate for weaker competitiveness and to achieve a rebalancing of the economy towards investments and external demand is by keeping the currency weak. Nevertheless, as growth conditions have improved substantially lately it is reasonable to expect a temporarily stronger currency. Yesterday we revised our 1m forecast for GBP/USD to at least 1.55 to reflect this before going lower again on the back of a generally stronger USD.
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