Provided inflationary pressures do not become excessive, monetary policy will not be tightened until the economic recovery is strong enough to make a significant dent in unemployment.
That was the message given by David Miles, a member of the Bank of England’s Monetary Policy Committee, in a speech given at Northumbria University yesterday morning.
Miles argued that, while recent improvements in economic data were welcome, the slack in the economy generated by several years of under-performance meant people should not expect monetary policy to return to normal any time soon.
It was important, he said, to distinguish between the economy returning to normal growth rates and the economy returning to a normal level of economic activity.
In fact, we must be conscious that this growth was coming from a depressed level of output.
“If that level of activity is significantly below a rate consistent with controlled inflation – as I believe is the case in the UK today – then it does not make sense to quickly return monetary policy to a more normal setting once growth moves to more normal rates,” he said.
“The reason I think guidance is helpful now is that it reduces the risk that a recovery that is still somewhat embryonic is not smothered by the anticipation that a tightening in monetary policy is imminent.”
Addressing the rise in market interest rates since forward guidance was announced, Miles said the market seemed to believe the unemployment threshold would be reached more quickly than he considers likely.
He emphasised the importance of studying how productivity - which has fallen substantially since 2008 - and argued it was plausibly it could pick up markedly as the recovery takes hold, resulting in unemployment falling more slowly than the market anticipates.
Miles rejected the notion that improving data meant that forward guidance had backfired, as this implies the MPC finds signs of recovery unwelcome – an idea that demonstrated a “rather Alice-in-Wonderland, upside-down logic”.
Rather, he would be “delighted” if growth turned out to be strong, productivity improved and inflation moved back towards the target level over the next eighteen months.
And if unemployment came down steadily and significantly as a result, he would be pleased to begin normalising monetary policy.
Miles also argued that quite different paths for economic activity can be consistent with very similar paths for inflation; low growth in nominal wages could be offset by low growth in productivity on a path where GDP grows only slowly, while higher wage growth can be offset by higher productivity when GDP grows more rapidly.
He said: “This is a powerful reason why an inflation targeting central bank should do all it can to get the economy on to the higher growth path. I view the main way in which forward guidance can help in the UK now is to raise the chances of staying on that more favourable path.”
While there could be no guarantees, he added, the recent rise in activity and confidence may have the potential to be sustainable and self-confirming.
“What a potentially self-confirming and stronger path for output and confidence does not need right now is tighter monetary policy,” he added. “That is what the guidance by the MPC is designed to avoid.”