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Bank of England ends link between unemployment and interest rates

The Bank of England will no longer use the unemployment rate as a trigger for considering whether the central bank interest rate should be increased, Governor Mark Carney has announced.

Presenting the latest inflation report by the Monetary Policy Committee (MPC), Carney said that recent signs of economic recovery were "neither balanced nor sustainable", despite the faster than anticipated fall in unemployment. He said that the second phase of the MPC's 'forward guidance', which will take effect once the unemployment rate falls to the previously-announced 7% threshold, would involve "gradual and limited rate increases" based on a range of economic factors.

Warning that the MPC would "not take risks with recovery", Carney said that interest rates could stay at the current historically low level "for some time to come".

"Forward guidance is working," he said. "Expected interest rates have remained low even as the economy has recovered strongly. Uncertainty about interest rates has fallen. Most importantly, UK businesses have understood the message ... virtually all businesses understand guidance, and almost three-quarters of them say it has boosted their confidence in UK economic prospects. In many cases guidance is encouraging businesses to hire and spend."

"[However] many of the headwinds holding back the economy will remain for some time yet. Public and private balance sheets continue to be repaired. Weak world demand and the appreciation of sterling will hold back the expansion of net exports. And there remain strains in the financial system despite good progress on post-crisis repair. These persistent headwinds mean that, even in the medium term, the level of interest rates necessary to sustain low unemployment and price stability will be materially lower than before the crisis," he said.

The Bank Rate of interest, charged to other banks on purchases of central bank money, has remained constant at 0.5% since March 2009. The MPC announced in August 2013 that it would hold this rate until unemployment fell to 7%, which it originally predicted would occur in 2016. Carney said that this rate had fallen "much faster than anticipated", and was now likely to reach the 7% threshold by spring.

In his speech, Carney said that a "substantial share" of those now in work included record numbers of self-employed people and those working part-time because they were unable to find a full-time job. At the same time productivity growth had been "disappointing", wage growth limited and global inflation rates subdued, he said.

The MPC's new guidance will be based on the amount of 'spare capacity' in the economy, as demonstrated through a "broad rage" of indicators including unemployment, participation in the labour market, average hours worked, the extent of involuntary part-time working, spare capacity in companies, labour productivity and wages, Carney said. The MPC has published initial forecasts of 18 economic indicators, to "allow others to monitor how the economy is evolving relative to our projections". The figures are based on maintaining an inflation rate of 2%, and indicate that the interest rate could rise to 2% by 2017 with the first gradual increase anticipated in spring 2015.

According to the inflation report, around 1-1.5% of current national output amounts to 'spare capacity' that can be absorbed by the economy before interest rates need to rise. The MPC's new guidance states that it is planning to absorb all of this capacity over the next two or three years. It will also maintain the current £375 million stock of asset purchases under the quantitative easing (QE) programme until the interest rate begins to rise again.

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