Forward guidance version 2: will the public believe it?

What isn't clear from the Bank of England's inflation report is why the new form of forward guidance will be any more reliable than the old form
Bank of England
The Bank of England slashed rates to 0.5% in March 2009 and they have stayed on 'emergency setting' ever since. Photograph: Yui Mok/PA

Forward guidance is dead. Long live forward guidance. That was Mark Carney's message as he sought to persuade businesses and households that interest rates are staying put at 0.5% for quite a while yet.

What was clear from the Bank of England's February inflation report is that the nine-strong monetary policy committee intends to keep supporting economic activity. Despite the pick-up in growth over the past year, Threadneedle Street thinks there is still enough slack left as a result of the deepest recession in living memory to warrant keeping borrowing costs on hold.

Even when they do start to go up, and the City thinks that is unlikely as things stand until 2015, the Bank will edge interest rates up in quarter-point moves. The peak will be 2%-3% rather than the 5% that was the norm before the financial crisis. The plan is to give firms and individuals the security to take out loans safe in the knowledge that they will not be hit by a sudden upward lurch in interest rates.

What was far less clear from the inflation report and Carney's hour-long press conference, was why the new form of forward guidance will be any more reliable than the old form, and whether the public will understand the Bank's thinking. Or, to be blunt, whether it will consider the guidance in any way reliable given the Bank's dodgy forecasting record.

Forward guidance mark one involved targeting unemployment. When the jobless rate fell to 7%, the MPC pledged to have a think about whether rates should be increased. It chose unemployment as a yardstick because the labour market data is not revised, everybody knows what it is, and the Bank considered it be the best proxy for the amount of spare capacity in the economy. It looked at a range of other indicators and rejected them all.

The Bank originally said that unemployment would take two-and-a-half years to get down to 7%. In the event it has taken less than six months, which has forced a crash rethink.

Forward guidance mark two involves the Bank's assessment of the output gap, which has none of the advantages that unemployment has as a yardstick for making policy transparent and predictable. Why? Because very few people know what an output gap is, and even those who do understand the concept have widely different views about how big it is.

Put simply, the output gap is the difference between the actual level of activity in the economy and its potential level. Policymakers assume that the economy has a long-term trend rate of growth, which in the UK's case is 2%-2.5%. In recessions activity falls below this level and so there is scope for the economy to grow faster than trend during recovery periods without inflation picking up. But it is also assumed that some of the damage caused by recessions is permanent, because investment is scrapped and unemployed workers lose their skills.

As a result calculation of the output gap is highly subjective. The Treasury publishes a range of estimates from forecasters and these vary from 0.8% to 6%. The Bank's estimate is 1%-1.5%, but that figure depends on a) the economy's trend rate of growth, b) the permanent damage caused by the recession, and c) likely productivity growth in the future.

All of which means forward guidance is now extremely fuzzy. The Bank will look at a range of indicators to judge what is happening to the output gap and, so long as inflation remains at or around its 2% target the MPC will be able to keep rates low. But make no mistake; the Bank does not really know how big the output gap is, nor how quickly it will close. And that makes its pledges on borrowing costs rather less cast-iron than Carney would have us believe.