Forward Guidance

What's it adding?

Last week the Bank of England, under new Governor Mark Carney, gave formal forward guidance on the future path of interest rates.  The Bank committed to keeping interest rates low until unemployment falls to 7.0 percent (it currently stands at 7.8 percent).  However, there were three caveats. The forward guidance would cease to hold if

·  in the MPC’s view, it is more likely than not, that CPI inflation 18 to 24 months ahead will be 0.5 percentage points or more above the 2% target; [or]

·  medium-term inflation expectations no longer remain sufficiently well anchored; [or]

·   the Financial Policy Committee (FPC) judges that the stance of monetary policy poses a significant threat to financial stability.

Markets behaved as if this was a tightening of policy, at least relative to what they expected (and such a move was widely anticipated).  Indeed, it is unclear how much this guidance adds to what we already knew.  The Bank's remit states that

In relation to monetary policy, the objectives of the Bank of England shall be:
  a.) to maintain price stability; and
  b.) subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment. [emphasis added]

Issuing guidance that monetary policy will remain loose while unemployment is high subject to inflation based caveats is not much more than a restatement of the above clause.  It certainly adds very little to George Osborne's recent update to the mandate, which emphasised that the inflation target is only the absolute priority in the medium term. Of course, the guidance gives some information to the markets about the bank's preferences by introducing the threshold of 2.5 percent.  But that is below even the 3.0 percent necessary for the Governor to have to write a letter to the Chancellor explaining what has gone wrong.  For all the fanfare, this watered down forward guidance has not added much.

A technical aside: this has been framed in the media as a commitment move.  But it is better seen as the Bank giving guidance on its preferences over output and inflation.  The classic Central Bank commitment problem is an inability to credibly promise higher-than-preferred future inflation, even when that would help push the real interest rate down to what is needed today.  However, the Bank is definitely not trying to promise future inflation - quite the contrary!

Inflation and tuition fees

Why count them?

Inflation is set to remain above the Bank of England's 2.0% target, according to today's Quarterly Report from the Bank of England.  The Bank points out that "increases in tuition fees...have added to inflation more recently".   Indeed, the rise to 2.7% in December from 2.2% in September "primarily reflected" increased fees and increased energy bills.  Education contributed on average 0.4 percentage points to CPI inflation in the fourth quarter of 2012.

Because inflation is calculated on a year-on-year basis, it will take many months before the increased tuition fees drop out of the headline inflation numbers.  Although the fees only went up once, you get 12 months of higher headline inflation figures as the comparison is with 12 months earlier.  Moreover, the contribution of fees has been "unexpectedly large".

The benefits of including fees in inflation are unclear, especially given the impact on the index.  The fees system in the UK is complex, and is most accurately described as a time-limited, contribution-limited graduate tax of 9% of earnings above £21,000.  Most students will not over their liftetimes pay the headline 'price' of £9,000.   To be sure, increased fees have an economic impact.  But the effect on purchasing power is much closer to that of increased income tax (which would not directly affect the index, but in the long rung would be deflationary) than increased prices.  Having fees in the index only obfuscates the true level of inflation.