The jobless rate in Britain is falling fast. Here’s why that’s a problem for the BoE

Score! The UK’s unemployment rate in the three months to November fell to 7.1% from 7.4%. That was much better than most analysts had expected.

Indeed, across most of 2013, the British economy recovered much faster than anyone anticipated.

And things look like they will get even better for the UK in 2014. Earlier this week, the International Monetary Fund IMF) upped its growth forecast for the UK to 2.4% from a previous estimate of 1.9%.

That places it just behind the US, which is tipped to grow at 2.8% by the IMF. In other words, Britain will be Europe’s fastest-growing economy this year.

A Daily Mail report highlights even better news: accountancy firm PwC predicts the economic growth in the UK will rise above its pre-recession levels for the first time in the final three months of 2014. The deficit is also forecast to fall below £100bn in 2014-15, for the first time since before the downturn.

While all this is wonderful news for the British economy, the improvements drop the central bank, the Bank of England (BoE), right in the middle of a dilemma.

BoE Governor Mark Carney had, last August, indicated that interest rates will not be raised until the unemployment level falls to 7%.

Of course, that was when most policy makers believed that the unemployment rate would stay high until 2016.

Now, there’s so much good news on the economy that the Bank probably can’t take any more. So, inevitably, it leads to the question: is it time for the central bank to raise interest rates?

Answer: It seems highly unlikely. On Wednesday, a central bank official reiterated that “the 7% unemployment level is only a threshold, not a trigger, and that the MPC (Monetary Policy Committee) sees no immediate need to increase interest rates even if 7% were to be hit in the near future.”

However, the rapid improvements in the labour market do threaten to dilute the impact of the “forward guidance” given by the central bank.

Given that economic growth and the jobless rate have not gone according to script, the limits of forward guidance are being strongly tested.

To the uninitiated, forward guidance is a tool used by central banks to “provide an indication to households, businesses, and investors about the stance of monetary policy expected to prevail in the future.”

Borrowing a sentence from the Federal Reserve: “By providing information about how long the policy rate will be kept low, the forward guidance language can put downward pressure on longer-term interest rates and thereby lower the cost of credit for households and businesses, and also help improve broader financial conditions.”

Now that the guidance doesn’t look like it will be followed up by action (an increase in interest rates), what will the BoE do?

There are three options: it can lower the jobless rate threshold, which give the bank some more room before raising interest rates; it can get rid of the guidance altogether; or it can change the words of the guidance to indicate the 7% is a threshold, not a trigger.

But all three options run the risk of hurting the credibility of forward guidance, because they indicate that the goal posts will be shifted when needed.

While it’s important to have flexibility in policy making, explicit quantitative targets have credibility only if the bank follows up with action when a target is achieved. If the target keeps shifting, well, why would you believe any target the bank sets today? After all, there could be a new target tomorrow.

In any case, it will be interesting to see how Carney retains the credibility of forward guidance when the MPC meets on February 6.

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