Uncertainty is an unavoidable element of policy decisions. In the words of the great Donald Rumsfeld, we must confront the unknown unknowns. In this appearance the BoE’s chief economist, Spencer Dale, discusses his approach to dealing with uncertainty in the context of forward guidance. Essentially, he says that the Bank doesn’t know how big the output gap is so it has been cautious with forward guidance. He suggests that any other course of action would risk pushing up inflation expectations.
His view is understandable, given the Bank’s inflation target, but it is probably not optimal for the UK. The Bank’s primary obligation is to ensure that inflation remains at 2 per cent in the medium term so I can see why Dale would take the view that uncertainty should make them more cautious. However, if the true cost to the economy is a combination of both lost output and inflation, then it would be better if the Bank were less cautious.
First, uncertainty in the economy is likely to reduce the effectiveness of monetary policy. To be effective the Bank must be especially decisive in times of uncertainty, and that is the opposite of the cautious approach the Bank has taken.
The second reason is espoused by Alan Blinder. He points out that inflation can be effectively controlled by central banks through their standard tools, but lifting output has proven difficult at the ZLB. Consequently, the risks of being overly tight are far greater than the risks of being decisively easy. It is easier for a central bank to gain forgiveness for high inflation than to gain permission to lift output. That too militates in favour of decisive action when there is uncertainty about the output gap at the ZLB.
For both those reasons it would be better if the Bank had been bolder in its forward guidance. However, the MPC is merely executing its statutory duty. The responsibility for the cautious policy announcement lies with those who chose not to change the Bank’s mandate to explicitly include output in some fashion.