In a speech defending the central bank’s use of forward guidance, he argued that with Brexit talks entering “the most critical phase”, monetary policy could follow two broad paths.
In the event of “smooth” Brexit, with a transition period and a trade deal between the UK and the EU, policymakers would take a more conventional approach, with the path of interest rates driven primarily by demand.
But Mr Carney cautioned that if the transition were disorderly, or Brexit turned out to be materially worse than expected, the BoE could face the same trade-off as it had after the 2016 EU referendum, when it cut interest rates to avert the risk of a downturn, even though sterling’s depreciation was set to push inflation well above target.
“From a monetary policy perspective, the bank is ready for Brexit,” Mr Carney said on Thursday. “Observers know . . . that, in exceptional circumstances, we are both willing to tolerate some deviation of inflation from target . . . and that there are limits to that tolerance.”
Mr Carney used his speech to defend the central bank’s communication strategy, after criticism from investors who accused it of repeatedly fuelling expectations of interest rate rises, only to delay when the data disappointed.
He argued that forward guidance — while “not a promise of the future path of policy” — had helped explain how the BoE would set policy when the economy was undergoing big structural changes, allowing households and businesses to plan for the future while keeping short-term interest rate volatility low.
This was particularly pertinent to the UK, he argued, because it had suffered a series of supply-side shocks, of which “Brexit is the latest and potentially the largest”. [...]
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Related in the FT's View: A necessary statement of the obvious from Carney
[...] Many believe that in the long term the British economy will adjust and thrive, however its economic relationship with Europe might change. Right or wrong, this view is defensible and coherent. But for others to believe that a sudden end to the relationship with the continent, with no prospect of a replacement, would not cause a short-term shock is no less than bizarre.
The UK has a trading economy. A threat of a large reduction of commerce with its primary trade partner will damage confidence, lower investment, drive capital out of the country, and weaken the currency. The only question is one of degree. As Mr Carney points out, immediately after the referendum consumers looked past the disruptive potential of Brexit. But when the inflationary effect of the fall in sterling hit real incomes, Brits pulled back.
Mr Carney’s suggestion that average household incomes are £900 lower than they were expected to be before the referendum is inevitably controversial. It is, after all, based on an estimate rather than a fact. But it is very hard to deny that the UK’s economic growth, which has decelerated to become the slowest in the G7, has been dented by the possibility of a hard Brexit. The certainty of one would dent it further.
A disruptive Brexit is, rightly, not the BoEs central forecast. The most likely scenario is that the negotiations, and the economy, continue their gradual and uneven progress. But a rough departure is clearly a possibility. The government’s continued insistence on forms of Brexit that are flatly inconsistent with Europe’s core principles shows that political infighting could overwhelm British pragmatism. Brussels’ short-sighted rigidity about the Galileo satellite shows that Brussels is capable of ignoring its own best interest, too. The negotiations need not go wrong, but they could.
There is no weapon in the BoEs arsenal that can avoid the difficult adjustment, and fall in real incomes, that would follow a cliff-edge Brexit. Mr Carney knows this. It can, however, make the adjustment more gradual and thus less painful. Loose monetary policy, and a willingness to tolerate higher inflation risks to protect jobs, is just the start. The central bank can also provide liquidity to banks (which are, fortunately, already better capitalised than they were a few years ago). And finally, it can push institutions and regulators to act in crucial areas — for example, by ensuring that insurance and derivative contracts retain their validity after a sharp break-up. All of this will help. Mr Carney is not providing empty reassurance. [...]
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