Adjusting forward guidance: What’s the point?

Professor Moorad Choudhry

Incredible to believe that in many countries there was once a time when politicians set base interest rates. The independent central bank, pursuing monetary policy without the hindrance of short-term political objectives, is a relatively recent phenomenon. Even the U.S. Federal Reserve, regarded as a benchmark for central banks that don't suffer government interference, is only just past its 100th birthday. This may seem a long time but not when we remember that commerce and some form of money and banking are at least 2000 years old in recorded history.

The Bank of England
Andrew Holt | Photographer's Choice | Getty Images

In this timescale the Bank of England (BoE) is a relative newcomer. It only achieved its independent monetary policy mandate in 1997, having been set up in 1694. That's a long time to wait to be allowed to do one's job! And just recently it has adopted the "forward guidance" approach of the U.S. Federal Reserve. Part of this guidance is to announce that interest rates will not be moved until the level of unemployment has fallen to a pre-specified level (with certain caveats).

(Read more: Should the Bank ofEngland abandon forward guidance?)

This column has spoken previously about the wisdom of tying base interest rates to the level of unemployment, so there's no need to discuss that again. This week we're more interested in a news item that suggested that, having indicated that rates would not move until the level of unemployment fell to 7.00 percent (from a current level of about 7.6 percent), the BoE was considering whether that trigger level should be lowered, perhaps to 6.50 percent or so.

Is the BoE's forward guidance 'botched up'?

If that happens, am I the only one to wonder, "What's the point?" I mean, the rationale behind Forward Guidance is supposed to be that it removed uncertainty about volatility of interest rates and so aids commercial decision making. Linking the base interest rate to a trigger point like unemployment, whether one agrees with that logic or not, is supposed to send a signal about when rates are likely to move.

But if I change the trigger point whenever I feel like, what's the point? How can it remove uncertainty? Or is the reality that if we set the trigger point far enough away from now it will remove uncertainty anyway?

(Read more: UK unemployment falls, putting rate hike in focus)

If central banks do change the trigger point frequently and unexpectedly, we may as well return to the bad old days when a change could come at any time, don't call us we'll call you, thank you very much. In which case, as an idea Forward Guidance would seem to have become past-it before it even reached voting age.

Professor Moorad Choudhry is at the Department of Mathematical Sciences, Brunel University and author of The Principles of Banking (John Wiley & Sons 2012).