No need to panic about interest rate rises as we are still in a bad place, but an improving place economically.

Yes “Forward Guidance” is dead because the Bank of England got their unemployment prediction wrong, but we still don’t really know why.

Unemployment dropped to 7.1% from 7.7% in three months making redundant the figure of 7% unemployment being any kind of trigger for looking at the bank base rate. This drop is statistically unprecedented being 4 times more than any previous drop for the same level of growth!

However Forward guidance could be said to have been a success by giving confidence for the economy to grow with GDP increasing by 0.7% in the 4th quarter. Forward Guidance was largely understood to have a stabalising effect by the business industry even if it wasn’t by households and popular press.

The irony is that the growth was largely caused by household spending even though incomes are stagnant and not any productivity increase, although construction figures have recovered.

This growth in household spending on goods and services could be pent up demand from previous years de-leveraging household debt. Eg a new car purchase may have been put off since the credit crunch, but now it is getting older and more expensive to run people are now making those purchases. This type of growth is not sustainable in the long term and is why the Bank of England are cautious about the future recovery especially with heavy economic headwinds from European demand falling.

We are still buying more from abroad and with European growth stalling and hence demand for our goods and services so our trade deficit is actually worsening. It is the strength of the Pound, which although having a positive effect on keeping external inflation lower, is making our exports less attractive. This is the age old economic conundrum that what is good for one part of the economy is usually bad for another.

 

 

Looking forward The Bank of England believe there is still a lot of spare capacity in the labour market and that is what should be targeted to see a sustainable improvement in growth. What they mean is that on average workers are underemployed and could be more productive. During the recession output dropped by a far greater ratio than employment and especially considering the recent figures on unemployment there must be spare capacity for employees to be more productive.

 

It is this spare capacity that the Bank of England are going to be carefully monitoring and targeting for any future decisions on monetary policy. The Bank of England believe that the natural level for unemployment is around the 5% point and that we are unlikely to see too much wage lead inflation before this is reached.

So in summary the good news is that the main target figures of growth at 2% and inflation at 2% are on target, but productivity is slow and the trade deficit is increasing. Therefore there is no short term requirement to dampen a fragile recovery by increasing interest rates and if there is any need to do so in the medium term it would be by very gradual small amounts.