Fashion for forward guidance leaves central bankers in a muddle

Just like food and clothes, monetary policy too has its fashions.

“Forward guidance” — the promise by central banks to keep interest rates low — is so 2013 that one rarely hears it mentioned these days.



Yet, while guidance may be yesterday’s fad its effects could not be more visible on the financial markets.

As central banks edge closer to raising rates, failure to provide clear advice over what happens next is agitating investors — with the split at the top of the US Federal Reserve proving particularly enervating.

“[The Fed’s] ‘talking’, or guidance, has now become disruptive,” said Erik Nielsen, chief economist at UniCredit. “Transparency ... is one thing, guiding the market is an entirely different thing, which so easily moves from being tricky but helpful, to becoming a real mess.”

As the recovery gathered pace, the Fed and the Bank of England have both softened their promises and gone increasingly “data dependent” — setting policy on the basis of the most recent wage, price and unemployment data.

The European Central Bank may have retained its own promise not to increase borrowing costs for some time, but its bigger preoccupation in 2015 has been a programme of quantitative easing, which the ECB launched in January and may expand in the coming months.

If vows to keep rates low initially helped central bankers reduce market volatility and foster the recovery, they also carried costs.

As Andrew Filardo and Boris Hofmann from the Bank of International Settlements warned in 2014: “If financial markets become narrowly focused on certain aspects of a central bank’s forward guidance ... recalibration of the guidance could lead to disruptive market reactions.”

Estimating the impact of forward guidance on the economies where it was tested is hard. Central bankers uttered different kinds of promises, some linked to time horizons, others to economic variables.

Moreover, these pledges often went hand-in-hand with other measures, including ultra-low interest rates and asset purchases, which make it harder to pinpoint their effects.

The BIS researchers have looked at the evidence from the US, UK, eurozone and Japan and concluded that while guidance helped to reduce the volatility of expectations about the future path of rates, it is less clear whether they provided a meaningful economic stimulus.


This view is disputed by central banks. For example, survey evidence from the BoE has shown that a majority of businesses polled in 2014 said guidance had made them more confident about the prospects for the UK economy — a finding that may suggest there may have been some positive effects.

Any discussion of guidance, however, should go beyond its immediate impact. Central bank-watchers should instead take a look at what has happened after the monetary authorities were forced to reformulate their promises in light of the economic upturn.

The outcome has been mixed at best. Mark Carney, Bank of England governor, gave last summer a vaguely worded speech in Lincoln Cathedral, saying that the decision on when interest rates will go up would come “into sharper relief” around the turn of the year. The wide time horizon implied in his words has allowed the bank to retain some credibility even as a slowdown in the global economy has made policymakers more cautious.

Conversely, Janet Yellen’s more specific call that she expected interest rates to go up by 2015 has come back to haunt her now that a “lift off” in December is looking less likely, prompting investors to wonder the usefulness of her words.

The parable of forward guidance holds lessons for QE, the other unorthodox policy tool central bankers have adopted to reignite growth since the crisis. So far, the assessment of the impact asset purchases had on inflation and growth has been broadly positive, though there are still doubts over its effects on inequality. However, with central banks still holding large amounts of government debt and other assets, any conclusion will hinge on how they manage the exit.

Fashions — even monetary ones — always look good when they first spread. The real question is whether they can pass the test of time.




Ferdinando Giugliano


Fonte: FT