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Forward guidance flops: The politics behind an early rate rise

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Bank of England Governor Mark Carney has refused to admit his forward guidance policy has failed. But it has.

In the Bank’s quarterly inflation report, published yesterday, Carney dropped the 7 per cent unemployment level as a threshold for interest rate rises.

Instead, interest rate rises will depend on a range of 18 factors including wages, productivity and spare capacity in companies.

It is only six months since the first radical change to monetary policy and it has been torn to shreds.

Forward guidance was designed to increase certainty but there is no certainty in economics, it makes fools of everyone. How has it created certainty when the Bank has twice overhauled the factors which inform interest rate setting in the space of six months?

Unemployment has fallen significantly since August, when Carney first set out his forward guidance plans. At the time the rate of unemployment was 7.8 per cent. In December the rate fell to 7.1 per cent and many economists believe it fell below 7 per cent in January. Even the Bank predicts a fall below 7 per cent by the spring.

Forward guidance was finished whether Carney changed the rules or not but he jumped before he was pushed.

Carney has tried to cool fears of a rate rise claiming they will rise gradually and stay low in the “medium-term”. He says the economy can maintain loose monetary policy for two or three years as he warned of economic headwinds.

To tie monetary policy to one economic indicator was always asking for trouble. The new broader measures look more robust and more accurately reflect the slack in the economy to cope with low rate rises.

Following the end of the Bank’s Funding for Lending scheme on mortgages in January, it is a further sign that monetary policy is being slowly tightened.

Quantitative easing, which now stands at £375bn, is highly unlikely to be increased further as the focus shifts to unwinding after the first rate rise.

So what does yesterday’s announcement mean for mortgage borrowers? Interest rates are more likely to rise sooner and more quickly as the UK economy recovers.

Market predictions expects the first rate rise to be gradual, to 0.75 per cent, in Q2 2015.

This would see rates rise before the May general election and create a real headache for a Government that has staked its reputation on low mortgage rates.

Fixed rate mortgages are already starting to edge up too after the end of Funding for Lending and an increase in gilt yields. The cost of funding in the markets is also increasing so mortgage rates will begin to rise from historic lows of less than 1.5 per cent for two-year fixes.

Rising interest rates could be seen as a sign of economic success. But the question is, will voters clobbered with higher bills see it that way?

The Bank of England has now linked an increase in base rate to wage inflation, which could blunt the impact of a rise as part of a Labour attack on the “cost of living crisis”. Even so, it may be enough to put Tory election strategists on alert.

The key message from the Bank’s changes is that forward guidance in its original incarnation has failed. It will be interesting to see the knock-on impact this will have, both economically and politically.

Samuel Dale is political reporter at Money Marketing – follow him on Twitter here

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