New output gap target is fraught with difficulties as unemployment link is scrapped - EY ITEM Club

12 February 2014

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  • Unemployment-linked forward guidance is scrapped
  • But targeting the output gap is fraught with practical difficulties
  • We expect the first rate rise in 2015Q3

Peter Spencer, Chief economic adviser to the EY ITEM Club comments on today’s inflation report:

“Today’s update to forward guidance was inevitable, with the recent improvement in unemployment having forced Mark Carney’s hand.

“The new policy can be boiled down to an output gap target. But while this may be theoretically sound, it presents a range of practical problems, not least because it cannot be measured. The Treasury’s latest survey shows a range of 0.8% to 6% for the current size of the output gap, demonstrating the challenge of targeting this measure. It is also going to be difficult to communicate it effectively to the markets. In short, the Bank has set themselves a much more complex task.

“Carney has insisted that rates will remain low for some time, which should put to bed the uncertainty surrounding the immediate path of monetary policy. But the outlook for the next couple of years is less certain and there will be an onus on the MPC to steer the markets through greater levels of communication, in particular more interviews and speeches.

“The Bank’s new guidelines for the pace of tightening do not alter our view that the first rate rise will come in 2015Q3. The Bank’s new guidance makes it clear that it wants to see a sustained pickup in real wages and a more balanced recovery and this timeframe should allow that to happen. It is also consistent with the inflation fan chart, where below target inflation over the medium-term points to an expectation of a slightly lower path for rates than the market anticipates.”