Despite struggling to get it right, central banks defend forward guidance

I don’t know about you, but I find it striking how the jawboning over forward guidance has shot up these past few days.

For the uninitiated, let me explain what forward guidance is. Forward guidance essentially involves communicating future intentions of the central bank to the public at large.

As the Federal Reserve explains on its website, forward guidance statements “provide an indication to households, businesses, and investors about the stance of monetary policy expected to prevail in the future.”

This week, the efficacy of such communication came under the spotlight as central banks and researchers presented their sides of the discussion.

One of the larger highlights was a research paper from the Bank for International Settlements (considered the central bank to central banks) that observed, among other things, that investors are encouraged to take higher risks because they believe forward guidance will provide ample warning before interest rates rise.

The strategy could also promote interest rates staying subdued for longer than required because central banks worry about market reactions to any possible hike in rates.

The two central banks that have come under the scanner for their use of explicit forward guidance are the US and UK, although other central banks, such as the Bank of Japan, have also been making explicit forward guidance statements. (For more details, read this post I wrote earlier).

In particular, the Bank of England (BoE) and the Federal Reserve linked a hike in the interest rates to a specific unemployment and/or inflation rate hitting a certain level.

Those levels are now dangerously close to being breached — and yet, neither central bank believes their respective economies are ready for an interest rate hike.

And now even a BIS paper warns that forward guidance carries risks.  So, is it time for a rethink on such guidance?

Doesn’t seem like it. On Tuesday, Charles Evans, the president of the Federal Reserve Bank of Chicago, stepped up to defend forward guidance, while noting that some changes to the guidance are likely, according to a Wall Street Journal blog post.

 “…there’s not a large expectation” the current system of numerical thresholds will remain in place for much longer, he said, adding that the Fed is likely to replace it with more “qualitative” guidance. Evans made his comments during a speech  in Georgia.

Another Fed president, Charles Plosser of the Philadelphia Federal Reserve, thought it would be better to lower the unemployment threshold (essentially, change the forward guidance) to 6.2% from 6.5%.,  a report by MT Newswires noted.

One more Fed official also joined the growing debate: New York Fed President William Dudley believes it’s time to dump the current explicit guidance in favour of more descriptive indicators.

As you can see,the future course of forward guidance is still being debated among Fed officials.

Meanwhile, across the Atlantic, it was the turn of the Bank of England’s governor, Mark Carney, to defend the bank’s forward guidance framework, according to a Marketwatch report.

On Tuesday, Carney emphasised that the forward guidance had helped the recovery of the labour market.

Nevertheless, the guidance was tweaked in February:  instead of focusing only on the unemployment rate as a trigger for a possible interest rate hike, the bank said it would focus on a range of indicators.

My take, as I’ve written earlier, is  that forward guidance is a useful monetary policy tool, but using it effectively still seems to be work-in-progress for central banks.

One thing does seem to be clear: In these uncertain times, qualitative guidance could provide more credibility to central bank intentions and monetary stance, as opposed to declaring explicit economic indicator targets to trigger monetary policy action.

As we’ve already seen, setting explicit economic targets for undertaking policy action runs the risk of central banks falling flat on their faces on their forward guidance if they become unwilling to take action when those targets are hit.

 [Image Credit]

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