The new governer will set out plans in response to George Osborne's request for a review of the current remit
The Bank of England governor, Mark Carney, will unveil new guidance for setting interest rates on Wednesday, in his most significant announcement since arriving at Threadneedle Street. He will attempt to convince consumers, small businesses and international money markets that only when the upturn is established will borrowing costs rise.
The more transparent stance by the Bank is in response to criticism that it has failed to create the foundations for long-lasting growth following the 2008 banking crash.
George Osborne asked Carney to review the Bank's remit, which is to maintain inflation at 2%, and consider whether broader criteria would allow the monetary policy committee (MPC) to take a more activist stance when setting rates.
Carney will lay out his plans at a televised press conference that analysts say will set the tone for his five-year tenure as governor.
The move follows a string of upbeat purchasing managers' index (PMI) surveys that show a broad-based recovery is under way. In previous recessions a similar recovery would force the Bank to consider raising interest rates, according to George Buckley, chief UK economist at Deutsche Bank.
The MPC, which Carney chairs, sets interest rates, primarily to keep inflation low. It is expected to adapt this remit to include giving "forward guidance" of its intentions, echoing the stance of Ben Bernanke, chairman of the US Federal Reserve, and his focus on the unemployment rate. Carney's guidance could take the form of a vague statement that interest rates will rise when the economic landscape looks better, or it could tie the hands of the MPC to a specific target. Here are the five options.
1.The MPC rejects forward guidance in favour of the status quo. Several members have already warned against an aggressive guidance policy, which they say gives a green light for investors to spend borrowed money on risky projects. Under this scenario, inflation remains the chief target with a secondary aim of supporting the government's economic objectives, including those for growth and employment. Carney, who favours forward guidance, would be humiliated.
Likelihood: the least likely outcome from the MPC meeting.
2. After accepting the need for forward guidance, the MPC agrees only to a form of words that links a rise in interest rates to an improving economic situation. A vague statement each month from the MPC would outline the prospects for rates over the following year. Speeches by Carney before his arrival at the Bank last month indicate he would be unhappy with this outcome, which is unlikely to alter fears among consumers and market expectations that interest rates will rise sooner rather than later.
Likelihood: Carney has signalled his unease with this scenario.
3.Copy the Federal Reserve and its unemployment target. The MPC would announce that until unemployment falls to its "natural rate" of, say, 6.5%, base rates will remain at 0.5%. The commitment would be tied to inflation staying below 2.5% over the medium term (around two years hence). Although many estimates of the natural unemployment rate in the UK are higher than 6.5%, the inflation backstop would provide some reassurance that policymakers would move to make credit more expensive should the impact of lower rates be felt more on inflation than employment.
Likelihood: the favourite.
4.A subtle twist on a commitment to lower unemployment would be a link to nominal GDP growth – the rise in market value of all economic goods and services without taking inflation into account. The MPC could set a target for three or four quarters of annualised nominal GDP above 6%. Buckley said: "It seems highly likely that Carney will focus not on current rates of economic growth, as indicated by the PMI surveys, but the level of GDP – which remains well below its pre-recession peak in the UK, unlike that of the US or Canada." But few consumers will understand how nominal GDP is calculated and what a rise would mean for interest rates, undermining Carney's aim of reaching beyond "central bank watchers".
Likelihood: unlikely, could be too confusing for consumers.
5.The MPC could signal that without a solid, long-term recovery it is prepared to tie an interest rate rise to a fall in unemployment. The announcement would be made alongside a large dose of extra quantitative easing. Since 2009 the Bank has loaned £375bn to financial institutions in the expectation they would pass it on in the form of loans to businesses and homebuyers. Carney's predecessor, Lord King, said the effect was to add two percentage points to GDP. Another dose of QE could do a similar trick, though most MPC members have rejected this remedy over the last year and there is widespread scepticism that pumping more money into the high street banks will spur lending.
Likelihood: unlikely, because MPC members might view a return to QE as too aggressive.