Mark Carney switches forward guidance rules as growth forecasts hit 3.4 per cent

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Mark Carney has been forced to overhaul his flagship forward guidance policy on interest rates, just six months after its high-profile launch.

The Bank of England's Governor said last summer that the Bank would not lift interest rates from their present record lows until the unemployment rate dropped below 7 per cent, something it did not foresee happening until 2016.

But the jobless rate has fallen much quicker, as the economic recovery has gathered pace, and the Bank forecast yesterday that the 7 per cent threshold would be breached in the first quarter of this year.

In response, Mr Carney unveiled what he called a "new phase" of guidance, saying the Bank could afford to keep rates on hold because there was still slack in the economy that needed to be used up. "There remains scope to absorb spare capacity further before raising the Bank rate," Mr Carney said, adding that the Bank's rate-setting Monetary Policy Committee judged that the economy's so-called "output gap" was currently around 1 to 1.5 per cent of GDP.

He denied that his flagship policy had been a failure. "Forward guidance is working," he said. "Expected interest rates have remained low even as the economy has recovered strongly and, most importantly, UK businesses have understood the [low rates] message."

The output gap is the degree to which the economy is operating below its theoretical potential. The Bank has never published its estimate of this metric before and it is impossible to confirm in real time. The Bank said it would continuously estimate the degree of slack by looking at "under-employment" levels and businesses' reports of their own spare capacity. It added that rates would need to rise before the output gap was fully closed.

City traders estimate that the first rise will probably come in the second quarter of 2015, close to the next general election. Mr Carney refused to give credence to that view, but analysts noted that the Bank did not call market rate expectations "unwarranted", as it did last summer.

Mr Carney added that when rates finally did begin to go up, they would do so only "gradually". The market consensus shows rates rising gradually to 2 per cent by 2017. The Bank added yesterday that even when the output gap had fully closed the appropriate level of interest rates would likely be "materially below" the average 5 per cent seen before the financial crisis.

The Bank upgraded its growth forecasts, projecting a 3.4 per cent GDP expansion this year, up from its 2.8 per cent forecast in November. It expects 2.7 per cent growth in 2015, also up on the 2.3 per cent it forecast three months ago.

However, Mr Carney warned that the recovery so far was "neither balanced or sustainable" and stressed that business investment needed to take over from household spending as a driver of growth this year.

The Bank also lowered its inflation forecast to below the official 2 per cent target at the end of this year, falling to 1.86 per cent in the final quarter of 2014.