Forward guidance has been around for a while (it was pioneered by the Reserve Bank of New Zealand 16 years ago) and can take many forms.
But, as the FT’s Frankfurt bureau chief Michael Steen writes here, all of them boil down to saying — or at least hinting at — what you’re going to do before you do it.
Until recently, guidance usually involved central banks using a mix of their economic projections and their inflation targeting frameworks to show markets whether their expectations of the direction and timing of policy changes were right or not. It was all a bit techy and abstruse.
No longer. Most of the focus recently has been on forms of forward guidance that the public — as well as markets — can easily understand. These more explicit forms of forward guidance involve central banks promising to keep monetary policy ultra-loose either until a fixed point in the future, or until economic conditions pick up.
What’s the thinking behind it?
One of the reasons why explicit commitments on interest rates have become so popular in recent years is that most of the major central banks are at, or are near to, the zero lower bound. (ie, they can’t lower their policy rates any further.)
At this point, policy makers need to look for new ways to get consumers and businesses to spend more and save less. Indicating that interest rates will remain low in the months and years ahead is one way of doing this because it creates certainty and lowers longer-term borrowing costs.
Lowering longer-term borrowing costs in turn solves another problem that has plagued central banks in recent years. Before the crisis, the short-term interest rates set by central banks would be passed on to longer-term borrowers. In recent years, however, the plumbing that transfers short-term interest rates to longer-term borrowing costs has been mangled. Forward guidance is one way of fixing that.
In recent months, forward guidance has served another purpose: it has been used to ready markets for central banks’ exit from the extraordinary monetary stimulus they have provided in recent years.
Which central banks have used conditional commitments?
The Bank of Japan was the first central bank to do so, saying in 1999 that rates would stay at zero until “deflationary concerns” were “dispelled.” The Greenspan-era Fed in 2003 also used a weak form of commitment to keep policy “accommodative”.
In April 2009, the Bank of Canada took guidance a step further by pledging to keep rates close to zero until the middle of the following year. The Federal Reserve soon copied them, before going a step further last December by ruling out any rise in rates while unemployment remained above 6.5 per cent.
In recent weeks, Ben Bernanke and other Fed officials have attempted to wean financial markets off their cheap and plentiful supply of cash by signalling that they plan to taper their bond buying towards the end of this year, should economic conditions continue to improve.
This use of forward guidance seems to have backfired, however, creating turbulence in financial markets – and a de-facto tightening in monetary conditions through a rise in global bond yields.
Where does the forward guidance offered today by the ECB and the Bank of England fit into this?
There was no explicit mention of the Fed by either central bank on Thursday – indeed ECB president Mario Draghi went as far as to deny that the governing council’s adoption of forward guidance was in any way influenced by the US central bank’s recent comments.
However, both the ECB and the Bank of England suggested the recent rise in market interest rates – which was triggered by the Fed’s shift towards the exit – were a key driver behind their actions. Both noted that the rise in yields sparked by talk of tapering had the potential to weigh on growth.
The ECB’s form of forward guidance is somewhere in between what the BoJ introduced at the end of the 1990s and what the Fed did in December.
Like the Fed, it ties any hike in rates to economic (and financial) conditions. In the ECB’s case, these are the “subdued outlook” for inflation over the medium-term; “broad-based weakness” in the real economy; and “subdued monetary dynamics”. But, unlike the Fed, there is no explicit figure. The syntax of the statement also implies that the ECB continues to attach more importance to inflation than unemployment and growth.
So the ECB has a lot more wriggle room, which sounds good for them but sort of defeats the point given that the idea of forward guidance is to provide more certainty to markets and the public.
The BoE’s form of guidance is also nowhere near as strong as the Fed’s. But at least they are willing to say in quite clear language that they think markets have got the timing of rate hikes in the UK wrong.
That gives markets more certainty than the ECB about when rates in the UK will rise. However, the market still expects the first interest rate rise in 2015, rather than the 2016 date forecast in May and June before the Federal Reserve signalled it would rein back its bond buying.
If the BoE wants to push expectations back to 2016, then it might have to make an explicit commitment to keep rates at their current record low until economic conditions measurably improve. The BoE hinted on Thursday that such a commitment could come in August.