There are two justifications for the market's disbelief in the Bank's forward guidance. One is that it's possible that the financial crisis has had a lasting adverse effect upon the UK's productivity growth. If so, then GDP growth will create lots of jobs, reducing unemployment quickly. Danny Gabay at Fathom Consulting says this could mean unemployment hitting 7 per cent next year.
The other is that inflation expectations are rising. The 10-year breakeven inflation rate - the gap between conventional and index-linked gilt yields is now 3.2 percentage points. That's almost a full percentage point higher than a year ago. Even allowing for an inflation risk premium and the tendency for RPI inflation to exceed CPI inflation, this means that market expects the inflation target to be missed, on average, over the next 10 years. Any further increase might therefore activate one of the Bank’s “knockouts” ; it has said it could raise rates if unemployment is above 7 per cent if medium-term inflation expectations "no longer remain sufficiently well anchored."
Equally, though, there are reasons to suspect rates won't rise for a long time. For one thing, it's not certain that the recovery can maintain its current pace; falling real wages and still-weak growth in the euro area could well slow growth. If slower growth combines with a pick-up in productivity, then unemployment might stay high for a long time. This would be especially the case to the extent that job creation reduces not unemployment but rather the numbers of economically inactive; in the second quarter, the latter filled over two-fifths of the new jobs. This mix of a productivity acceleration and supply of labour from outside the measured workforce would also help to keep inflation down.
The Bank has another problem. It's that if it raises rates quickly, businesses might fear a series of rises and so curb their investment and job creation in anticipation of higher borrowing costs. Of course, the Bank could try to signal that rates will stay low. But if forward guidance is seen to have failed, such signals might lack credibility.
Faced with these uncertainties, Brainard's principle comes into play. This says that, when faced with uncertainty, central bankers should act slowly and conservatively; commentators who accuse central banks of "dragging their feet" miss the point that feet-dragging is a feature of policy, not a bug.
We don't have to look far for a precedent here. After the early 90s recession, Bank rate continued to fall even as the economy recovered. In fact, rates didn't rise until real GDP was 5.5 per cent above its pre-recession peak. With the economy now still 2.5 per cent below its pre-crash high, this precedent suggests we might have to wait a long time for rates to rise.
