Forward guidance is getting a bit of a bad rep these days.
Understandably so. The US Federal Reserve and the UK’s Bank of England have both used this monetary policy instrument to manage expectations about the future course of monetary policy — and failed.
Indeed, providing indications on the future course of monetary policy by tying policy actions to the achievement of explicit economic parameters is feeling increasingly like a minefield: you don’t know when one will blow up in your face.
Take the case of the UK. In August last year, Bank of England (BoE) governor Mark Carney pledged to keep interest rates low until the unemployment rate fell to 7% (at the time, the bank estimated that level would be reached mid-2016).
Surprise, surprise. In December, the jobless rate in the UK slumped to 7.1%, a whisker away from the threshold at which the central bank said it would consider lifting interest rates.
But even though the UK economy is making remarkable progress, it’s not strong enough yet to justify a policy rate hike .
So the BoE’s forward guidance, in effect, cratered.
That left Carney with three options: one, ditch the forward guidance entirely; two, tweak the guidance (for instance, lower the unemployment rate threshold to 6.5% or 6%) but that risks undermining the credibility of further forward guidance statements, or three, (use a broad set of indicators instead of just one) to decide when to change monetary policy.
Across the pond as well, forward guidance has the potential to spike stress levels at the US Federal Reserve. It, too, had earlier pledged that it would not consider changing its super-low interest rate policy until the unemployment rate fell to 6.5%, again estimated to occur somewhere in the medium term.
But the unemployment rate in January has already declined to 6.6%, leading the central bank to announce that it will retain its easy money policy “well past” the jobless rate of 6.5%. It also tacked on inflation and other economic parameters as additional factors to consider before raising interest rates.
In both cases, now, forward guidance has become a little fuzzier. Fuzzier is good.
That’s because three things are becoming clear:
One, forward guidance is not a bad thing, but tying policy actions to one or two specific economic indicators right now isn’t a great idea.
An economy is a composite of a wide variety of data points, and while some of them are always more important than others, committing a central bank to a pre-set course of action based on one indicator leaves little room for discretion.
In these highly uncertain economic times, discretion — and the ability to think out-of-the-box — is very much required. In normal times, using one economic indicator might be more acceptable for monetary policy decisions.
Two, announcing explicit targets for economic indicators, while great for public consumption, are not so great for policy-making.
Such targets carry the risk of undermining central bank credibility if the bank hesitates to take the promised action once the target is achieved.
Three, tweaking forward guidance by changing the economic indicator targets makes matters worse, because its completely destroy the credibility of forward guidance. That’s why neither the Fed nor the BoE have chosen that option so far.
Good for them. If investors think achieving an economic indicator target will lead to a revision of that target tomorrow, why should they believe any forward guidance issued today?
Revisions do not help the cause of forward guidance. Instead, they make it seem like policy makers didn’t think through things clearly before deciding on the targets.
And of course, once that impression sets in among investors and the general public, central banks will have no choice but to bin forward guidance.
Forward guidance is a good monetary policy tool, but like everything else in the central banker’s toolkit, it has its limits.