The Bank of England’s knockout artist

LONDON ― In Canada, if you say you come from London, the natives often ask if you mean London, Ontario, or London, England. I always find the question somewhat irritating, perhaps revealing the persistence of an arrogant imperial mindset.

But soon, perhaps, they will no longer need to ask: in London, we are all Canadians now. With what one commentator described as “his rock star looks and PR charm,” Mark Carney, the former governor of the Bank of Canada, has taken the city by storm in his first weeks as Governor of the Bank of England.

Change is the order of the day at the Old Lady of Threadneedle Street. Out goes the fusty old inflation-targeting regime, with its fixation on the consumer price index and disregard for financial-sector imbalances. In comes a brave new world of “state-contingent threshold-based forward guidance,” complete with three conditional “knockouts” that would cause the guidance to be changed. We have had to learn a whole new lexicon of central-bank speak. These are heady times at the BoE (in the heart of the financial district of Ontario-on-Thames).

The simple point that Carney made in his first policy pronouncement was that interest rates will remain unchanged, and the BoE’s variant of quantitative easing will remain in place, at least until unemployment falls below 7 percent (from its current rate of 7.8 percent). Though it all sounded straightforward, markets were confused. The pound initially fell sharply, and then recovered, while long-term government borrowing rates have risen by around 30 basis points.

This outcome may not have been what the new governor intended, but it is perhaps not surprising. Though forward guidance is a useful part of the modern central banker’s tool kit, the Anglo-Canadian version on display in London is highly complex, mainly because it has been shoehorned into a policy framework designed for another purpose.

There are four related problems. The first is that the United Kingdom retains policymaking by committee. To his credit, Carney has succeeded in persuading most of his new colleagues on the Monetary Policy Committee to sign up to the new approach (we now know there was one holdout). That could not be taken for granted. Their views have often been split in recent years. But individual voting remains in place, so Carney is not in sole charge of policymaking, as he was at the Bank of Canada. Any future commitments are conditional on keeping a majority of the committee in line.

That leads to the second problem: the so-called knockouts ― the other factors that can change the direction of policy ― are clearly matters of judgment, not of fact.

The first knockout would occur 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 percent target.” The second is that “medium-term inflation expectations no longer remain sufficiently well anchored.”

There is plenty of scope for different judgments on both issues, neither of which lends itself to definitive answers based on solid numbers. And, sadly, when it comes to forecasting inflation, the BoE’s record has not been very good.

The final knockout ― which would occur if “the Financial Policy Committee judges that the stance of monetary policy poses a significant threat to financial stability” ― points to the third problem. The FPC is part of the complex new U.K. regulatory structure, in which the former Financial Services Authority has been split in two: a prudential and business-conduct regulator and a new body to monitor financial stability. The new FPC must give its advice publicly to the MPC when it has concerns.

The FPC, it should be emphasized, is chaired by the BoE’s governor, so there is an element of smoke and mirrors here. But its composition is different from that of the MPC, so its view on a particular policy stance may be different as well, and here, too, the governor has only one vote.

Some argue that it would have been simpler to merge the two, and the unwieldiness of the new means of articulating policy suggests that this might indeed have been a good idea. The BoE’s governor is now in the odd position of being invited to knock himself out ― and in public, too. That would be fun to watch.

The fourth problem is the most fundamental. The government has chosen not to change the BoE’s formal mandate. Its prime objective remains price stability, with real-economy factors relegated to the second order of importance. By contrast, the U.S. Federal Reserve has a dual mandate: price stability and full employment. Of course it must continuously balance the two, but both have equal weight.

It is the failure of the U.K. government to amend the statute that dictates the complex structure of knockouts that the BoE’s ingenious staff has been obliged to devise. The unemployment threshold, linked to forward guidance, can be seen as a backdoor way of adding a second objective. But one would surely not start from there if that were the long-term policy aim.

It would have been far clearer to address the issue head on and change the BoE’s mandate. That would have painted the new regime with a veneer of democratic legitimacy, giving it greater authority. The government, however, decided not to open up the issue in parliament.

The objectives of the new monetary-policy approach are admirable. The U.K. economy, while moving forward, is still operating well below capacity. But to keep all these balls in the air, and avoid knocking himself out, Carney will need all the creativity and agility of that other great Canadian export ― Cirque du Soleil.

By Howard Davies

Howard Davies, former chairman of Britain’s Financial Services Authority, deputy governor of the Bank of England, and director of the London School of Economics, is a professor at Sciences Po in Paris. ― Ed.

(Project Syndicate)