Why Mark Carney's unemployment peg is gutsier than the Fed's

Tying interest rates to the jobless rate is tougher in Britain

The Bank of England, London June 15, 2012. Paul Hackett/Reuters

The Bank of England announced today that it will keep interest rates at record lows until Britain’s unemployment rate falls to seven per cent, provided inflation expectations don’t get out of hand. It is a bold move — the Financial Times called “regime change” at the Old Lady of Threadneedle Street, as the BOE is affectionately known — and it comes from Mark Carney, former governor of the Bank of Canada, now head of the venerable British central bank.

The new policy aims to reassure investors and households that interest rates will stay very low for a while longer and thus encourage them to borrow more and save less to stimulate the economy. Alongside its statement on interest rates, the bank released economic projections showing it expects the jobless rate to reach the fateful seven per cent level around mid-2016, implying that the British public shouldn’t worry about borrowing costs increasing until then (unless, that is, the bank significantly reassesses its forecast).

You might yawn, and say, “this looks like exactly what the Fed is doing right now.” In part, you would be right. Since December 2012 the Federal Reserve has pledged to keep interest rates at rock bottom until the unemployment rates falls below 6.5 per cent (although now it is considering an even lower target), provided inflation doesn’t rise past 2.5 per cent. Carney is clearly borrowing a page from Fed Chair Ben Bernanke.

That’s hardly surprising. When he was still at the BOC, but had already publicly accepted the gig at BOE, Carney openly endorsed Bernanke’s unemployment peg. He also publicly rebuffed former BOE Governor Sir Mervin King, who had said he believed the British central bank had run out of tools to stimulate economic growth. Carney told reporters there were still things the BOE could do. He didn’t say what exactly, but given that the Britain was already experimenting with quantitative easing, the practice of printing money to buy massive amounts of assets, it would have been a good guess to suppose Carney was referring to the other unconventional monetary policy that has become popular after the financial crisis: Promising low-for-long rates, or “forward guidance” in central bank lingo.

Still, Carney’s decision to anchor inflation expectations to the unemployment rate in Britain is even bolder than Bernanke’s original move to do so in the U.S., for three reasons.

First, while the Fed’s has a double mandate to keep prices stable and foster maximum employment, the BOE’s only statutory objective is to keep inflation in check. When Bernanke introduced the Fed’s unemployment target he simply shifted the bank’s focus more on one of the bank’s two mandates than the other. Carney has the more difficult task of explaining why fixating on unemployment fits with the bank’s only goal of keeping prices stable. Here’s the BOE said on that this morning:

This approach is consistent with the MPC’s [the Monetary Policy Committee, the BOE rate-setting body] objectives, as defined by its remit. The MPC’s primary objective is to maintain price stability – as defined by the Government’s 2% inflation target – and, subject to that, to support the Government’s economic policies, including those for growth and employment.

Second, while inflation is very low in the U.S. right now, Britain’s is stuck at 2.8%, well above the BOE’s target of two per cent. The rule of thumb in monetary policy is that low interest rates push prices up, and high rates push them down. The Fed argued that it could keep rates very low for a long time without triggering excessive inflation because a) inflation was very low to start with and b) the economy was so anemic that it would take a while perforce prices would start rising again. The BOE clearly can’t make that case. Addressing that issue, the bank has said it will abandon its unemployment peg if it believes inflation is likely to rise past 2.5 per cent in the medium term, meaning one-and-a-half to two years from now. In other words, Carney seems to think the bank can afford not to worry about the current inflation rate, as long as expectations about the future rate don’t rise too high. He might be right, but inflation hawks won’t like it.

Finally, unconventional monetary policy has failed to work its magic on Britain so far. The jury is still out on the QE in the U.S., but Bernanke has made a convincing case that the Fed’s massive bond-buying program has helped re-inflate U.S. housing prices. The BOE’s QE, by contrast, is widely considered to have been a failure. Will Carney have better luck? Many Britons are understandably sceptical.

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