Bank of England to Estimate Interest Rate That's Just Right
(Bloomberg) -- The Bank of England is about to try to put a number on normality.
After months of research, the central bank will provide an assessment of the Goldilocks interest rate for the first time when it announces its policy decision on Aug. 2. Known as r* (r-star), it’s the rate that keeps the economy neither too hot nor too cool over the long term.
The publication could help indicate where officials see the benchmark rate settling as they move away from ultra-accommodative monetary policy put in place in the wake of the financial crisis.
With a rocky track record providing guidance in the past, though, the BOE has to be careful that its new forecast isn’t interpreted as a promise waiting to be broken. Governor Mark Carney has backtracked repeatedly on when and how quickly the bank might raise interest rates in his five-year tenure so far.
For starters, the equilibrium rate -- both globally and in the U.K. -- isn’t permanently fixed, and policy makers say it’s now slowly rising after slumping in the wake of the financial crisis.
Economists estimate the “new normal” rate for the U.K. as anywhere between 1.5 and 2.5 percent over the next few years. The BOE’s benchmark rate is currently at 0.5 percent.
“By giving some indication of what they think the neutral rate is, we’ll have a better idea of what the glide path is to that,” said Hetal Mehta, an economist at Legal & General Investment Management in London. “It’s to give an anchor, it’s an extra tool, a part of their communications strategy and part of forward guidance.”
While the estimate is important, it may be overshadowed on Aug. 2. The BOE is widely expected to tighten monetary policy, raising its key rate to 0.75 percent. That would be a second hike since November, and policy makers say households should expect rates to rise several times over the next few years.
Asked after a speech Monday whether he would vote for a rate increase, Deputy Governor Ben Broadbent said he didn’t know and wouldn’t say how he would vote.
The BOE will also be sensitive to the risk that investors will interpret the neutral rate estimate as a target or a promise. When Carney introduced forward guidance to the BOE in 2013, he quickly ran into trouble, having pledged to consider a rate increase after unemployment fell below a certain threshold. In reality, he found joblessness fell faster than expected and rates stayed stuck.
Bloomberg Economics forecasts that the neutral rate is currently between 0.75 and 1 percent, and will probably rise to around 1.5 percent by the end of the bank’s three-year forecast horizon. Kallum Pickering, an economist at Berenberg, says the bank will probably estimate a rise to 2.5 percent in that period, while JPMorgan economist Allan Monks gives a range between 1.5 and 2 percent.
Former Federal Reserve Chair Janet Yellen said “monetary policy should be at neutral only when economic conditions are ‘just right.”’ By most estimates, the U.K.’s output gap is closing and the BOE says inflation will return to its 2 percent target in the next few years, suggesting interest rates should be raised to neutral just to keep the economy from overheating.
Some BOE rate voters have commented on where the neutral rate might be going, without offering a precise estimate of what it is. Gertjan Vlieghe, an expert on the topic, is said to be a driving force behind the BOE publishing its neutral rate forecast.
He said earlier this year that he sees one or two quarter-point rate increases annually over the next three years, though the neutral rate is probably “well below” what it was before the recession.
That means that “even if rates were to rise a little faster than markets price in, I think that the general picture is still limited and gradual, not too far, and not too fast,” said BOE policy maker Michael Saunders, who has voted to raise bank rate for the last three meetings, earlier this month.
Carney said in May that the nine-member Monetary Policy Committee was reviewing the “possible range” for the equilibrium real rate in the medium term.
There are still plenty of potential obstacles on the path to normality for the Bank of England, including Brexit or global trade wars.
But economists say the effects of the financial crisis on the Goldilocks interest rate are dissolving. Those include weak productivity growth, fiscal consolidation, wide credit spreads, risk aversion, reduced capital spending and the post-crisis emphasis on balance sheet repair.
A neutral rate estimate is “trying to give people an idea of what normal actually means,” said Andrew Goodwin at Oxford Economics. “It’s long overdue.”
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