Forward guidance more than passing fashion for central banks
16 Jul 2013 - {{hitsCtrl.values.hits}}
By Sakari Suoninen
“Watch what we do, not what we say,” was the central bank mantra for generations. But no more.
In the space of a few hours last week, the European Central Bank and Bank of England embarked on a momentous change, moving to provide an interest rate outlook as the Federal Reserve already does, a crisis response that could become a permanent feature.
Market turbulence after the Fed floated an exit plan from its money creation programme forced them to give “forward guidance” on rates for the first time to try and temper rising bond borrowing costs.
While the Bank of England will spell out its plan in detail next month, it said markets were over-aggressive in pricing in rate rises. The ECB contented itself with saying rates would stay at record lows for an “extended period” and could fall further.
ECB chief Mario Draghi called the move “unprecedented”, showing that ditching the tradition of not pre-committing proved hard. Previously the ECB used code words such as “strong vigilance” to hint at rate moves a month or at most two in advance.
“No pre-commitment was the bible for the ECB for many, many years,” Graduate Institute of Geneva Professor Charles Wyplosz said. “The new management of the ECB has already rewritten the bible in many ways, in good ways.”
Guidance has come a long way
Central bank guidance has come a long way. Looking back a generation, some did not even publish their interest rate decisions, but let markets figure them out. This included the Fed, which started publishing them only in 1994.
Since then, central banks have increased the flow of information to markets, including post-rate decision news conferences, and now forward guidance. The first central bank to start regularly delivering that was the Reserve Bank of New Zealand in June 1997, followed by Norway and Sweden.
Graeme Wheeler, head of New Zealand’s central bank, said in March a rate path gives consumers greater confidence, helps shape inflation expectations and anticipate policy responses, thus smoothing excess volatility.
“When market expectations adjust smoothly and efficiently, it can diminish the need for larger policy adjustments,” he said.
This reasoning is widely shared by economists supporting forward guidance, while those opposing it fear it could hurt central bank credibility if they drop the anticipated policy.
The Fed began giving forward indications a decade ago and recently evolved its approach to a more precise one where it now says rates will not rise until the U.S. unemployment rate, now at 7.6 percent, falls to 6.5 percent.
However, the U.S. central bank’s latest gambit - to signal an exit from money-printing perhaps by mid-2014 - shows clarity is not always easy to come by.
Markets sold off after Fed Chairman Ben Bernanke announced the plan but have since been tossed this way and that by every subsequent utterance. For example, stocks climbed around the world on Thursday after Bernanke comments playing down the strength of the U.S. jobs market were taken to mean withdrawal of stimulus was further away than had been expected.
For central bankers, every single word can count. Convoluted messages about what the ECB means by an “extended period” have emphasised that.
Executive Board member Joerg Asmussen told Reuters on Tuesday that the pledge was good for “beyond” 12 months but the ECB rushed out a statement insisting he had not intended to give any guidance on exact timeframes.
Jens Weidmann, the boss of Germany’s hawkish Bundesbank, said on Thursday that the ECB had not “tied itself to the mast” and could raise rates if inflationary pressures emerge.
Costs and benefits
The main reason central banks are now rushing to providing more information about rate expectations is that having exhausted their ability to lower short-term interest rates, they seek to ease policy further by pushing down long-term ones.
“It could be interpreted as more monetary stimulus ... which contributes to lower longer term yields, hence stimulates economic activity,” according to research by the New York Federal Reserve, which added that on the downside it could be seen as “revealing negative news about the state of the economy”.
Now, the positives are seen outweighing the negatives not least since sluggish political progress on getting public finances back into shape has meant central bankers are de facto running economic policy.
But even as they have been pushed into giving forward guidance, central banks may well find that the sharpening of crisis communications is a useful permanent feature.
“The ECB is just starting on this route. It’s only the first step, but the first step is crucial,” Wyplosz said.
In Britain, new BoE Governor Mark Carney is widely expected to back the case for forward guidance, something he pioneered while in charge of the Bank of Canada. That could, for example, encourage home owners to spend more if they are convinced their mortgage payments won’t go up.
That could initially work more effectively if forward guidance was based on a period of time rather than an economic target such as the growth or unemployment rate.
But some policymakers are wary of that, fearing they could be boxed in and risk weakening a mandate to keep a lid on inflation. Time lines can also change too frequently to offer the public much certainty.
Both the Swedish and Norwegian central banks offer future rate paths which currently show no tightening well into next year. But those paths are subject to change at each policy meeting.
Permanent feature
The Fed has tried it both ways. Early experiments began under Alan Greenspan, when the central bank promised to leave interest rates low for a considerable period in 2003.
During the financial crisis, as the central bank slashed interests rates rapidly towards zero, it first promised to keep rates low for “some time”, and then, eventually, for an “extended period” - exactly where the ECB is now.
In 2011, the Fed adopted calendar guidance, saying it would keep rates low until at least 2013. Because of concerns among policymakers that this guidance gave a pessimistic message on the economic outlook, thereby creating an additional drag on sentiment, the Fed adopted a new threshold system last December.
Then, it pledged to leave interest rates near zero until the jobless rate falls to 6.5 percent, as long as inflation is not forecast to rise above 2.5 percent over a one- to two-year horizon.
Data-driven guidance is likely to be the route for most central banks, as it avoids the trap of tying one’s hands while increasing visibility about the future.
“They know what has to be done, so it won’t take them years to do conditional forward guidance,” Wyplosz said, while adding that agreeing on thresholds could be exceptionally difficult for the ECB, since any single measure carries less weight across the whole euro zone.
However it is done, with countries struggling to revive growth after a brutal crisis, forward guidance is likely to be here to stay.
“Forward guidance seems to be the new black among central bankers,” Nordea analystAnders Svendsen said.
