Counterfactuals won’t help the Bank this time

Ben Chu

As well as proclaiming “decisive” victory for Osbornomics yesterday, the Chancellor made another striking claim: that the Bank of England’s forward guidance is working.

He told his audience:

“Some have interpreted more recent increases in gilt [government bond] yields as a sign that forward guidance has somehow failed, but that is, I believe, a misunderstanding. I’d argue that market movements since the August Inflation Report vindicate the need for forward guidance: the counterfactual would have been even bigger increases in yields in response to positive economic data.”

So it’s our old friend the counterfactual: it’s not failed because things would have been worse without it.

It’s not completely spurious. It’s certainly possible that traders would have priced in an even earlier rise in base rates without the Bank’s pledge to hold down rates until around 2016.

Now the Bank is normally fond of counterfactuals. It has argued in recent years that the economy would have been worse off without Quantitative Easing and that lending would have been weaker without its Funding for Lending Scheme.

Yet I don’t think this is a shield the Bank itself can credibly reach for in this instance.

That’s because the Bank, strictly speaking the Monetary Policy Committee, showed it’s own rate expectations early and clearly.

On 4 July, after its monthly meeting, the MPC released a statement that said this:

“In the Committee’s view, the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy.”

But since that “rate protest” traders have actually brought forward their estimates of when the first rise in base rates will come, as the chart below (which uses interest rate swaps rates to show the implied UK interest rates yield curve) shows.

The yellow line is the implied curve on 4 July, when the MPC released its statement. The green line is the yield curve today.

sonia1 Counterfactuals wont help the Bank this time

What this shows is that in July traders were expecting base rates to edge above their present historic low of 0.5 per cent in the middle of 2015. Today the City expects that to happen in just 18 months’ time.

So the Bank of England will have trouble echoing the Chancellor’s counterfactual defence of forward guidance’s effectiveness (thus far) because if Threadneedle Street believed traders’ expectation of rate rises were “not warranted” in July how can it believe expectations of an even more rapid rise to be warranted now?

One response might be that growth indicators have generally surprised on the upside since July, which might have shifted the Bank’s view. And it’s true that the minutes of the MPC’s August meeting showed that “some members did not think market interest rates were obviously out of line with their view of the outlook”. Yet the Bank’s Governor, Mark Carney, stuck to his stance on the timing of rate rises at his first speech in Nottingham last month. Moreover, if the Bank were to concede that it has fundamentally revised its growth and unemployment forecasts in the month since they were published that would risk unravelling forward guidance entirely.

Such a revision would mean that if the public and traders want guidance on the likely future path of rates, they are better off looking to the economic data flow, rather than the words of the Bank of England: in other words the very reflexive behaviour Mark Carney and the Bank designed forward guidance to override.

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