On 7 August 2013, the Bank of England announced that it will not consider raising Bank Rate from its current level of 0.5 per cent (or unwinding its asset purchase programme) until the unemployment rate has fallen to 7.0 per cent. But this forward guidance will no longer hold if any one of three knockout conditions is breached: CPI inflation in 18-24 months is more likely than not to be 2.5 per cent or more; medium-term inflation expectations are no longer sufficiently anchored; or, financial stability is put at risk by the monetary policy stance.
This guidance was announced with three stated goals: to clarify the Bank’s view on the trade-off between inflation and supporting the recovery; to reduce uncertainty about the future path of monetary policy; and, to allow the Bank to explore the scope for higher economic growth while maintaining price and financial stability. The guidance provides thresholds rather than triggers for decisions, which means that neither the unemployment rate reaching 7.0 per cent nor a breach of the knockouts would necessarily result in a tightening of monetary policy.
Our forecasts are conditioned on market expectations for Bank Rate, so we have not made an explicit judgement about the effect of forward guidance on the future path of interest rates. As it happens, we forecast that unemployment will reach 7.0 per cent in the second quarter of 2015, one quarter before the market has fully priced in the first 25 basis point Bank Rate increase.
Our forecast does not imply that any of the knockouts would be breached. Our forecast for inflation in 18-24 months’ time is 2.3 per cent, comfortably below the 2.5 per cent threshold. Also, we assume that inflation expectations remain well anchored, which is one reason we do not forecast that inflation will fall below target despite a negative output gap over the forecast period. Finally, we expect financial stability risks to be contained over the forecast period. Despite the recent pick-up in house prices and housing market activity, as the Bank of England notes, “there is little evidence of an immediate threat to stability”.a A greater threat could arise if there is excessive growth in household debt or weakening of underwriting standards, but we assume that these risks are managed successfully by the financial stability authorities.