Anyone with a penchant for nostalgia might equate the new policy with the obsession of British governments between 1945 and 1976 with running the economy in order to preserve full employment. That turned out to be ultimately disastrous for inflation, but the new policy has a inflation safety valve that allows governor Mark Carney the option of ditching the target if needs dictate it. The really interesting point is the thinking behind it. Basically, the Bank is not concerned about whether there are enough people stacking shelves at Tesco, what really matters is whether productivity can improve without stoking inflation. And it is this measure of productivity and output that will really determine whether interest rates go up, or stay low.
One of the great mysteries of the last recession was how employment held up relatively well after five years of economic growth went down the drain. Theories abound about whether companies were hoarding labour, or whether workers were simply pricing themselves back into the job market. Neither is particularly definitive as an explanation, but it probably helps that the UK economy and labour force is far more flexible and mobile than during previous recessions. A more interesting theory, and one that likely informs the Bank's thinking, is that productivity reached a cyclical peak shortly before GDP growth topped out in 2007. The fact the growth we saw between 2001 and 2006 was probably flawed from an economic point of view, due to the boost from overly cheap credit, means that the post-crisis output per worker is likely to be closer to the long-term average than might otherwise have been expected.
That is particularly true of sectors such as manufacturing, which has been enjoying a sudden growth in output this year. According to data gathered by Morgan Stanley, manufacturing in the UK had already undergone a large-scale restructuring shortly before the financial crisis, with output rising by 6 per cent, despite a 500,000 fall in manufacturing employment. That's left at least 10 per cent of the UK economy looking quite lean in comparison with the arguably over-manned, and much larger, financial services sector, which is why it doesn't affect the aggregate productivity figures.
The point then for monetary policy is that if productivity starts to recover in line with a cyclical upturn in GDP growth, then there may not be the accompanying inflation to force interest rates up. In many ways, though, it is a gamble, as one long-term Bank of England watcher puts it: "If productivity recovers, then no inflation and Carney looks clever. But if it doesn't, then he looks foolish, although he can always blame the lack of supply-side reforms, like Mervyn King (the former governor) started to do before he left." In short, rates will probably rise in the next three years, but when, and by how much, will depend on how much harder we are prepared to work.
Chris Dillow is currently on annual leave.
