The strange death of forward guidance
The Bank of England’s Monetary Policy Committee’s guidance on when interest rates will rise keeps changing. Should it be abandoned?
The governor of the Bank of England (BoE), Mark Carney, was an enthusiastic advocate of forward guidance when he took office in mid-2013. Indeed, he had been a pioneer of this approach since 2009 as governor of the Bank of Canada. By adopting forward guidance, the central bank takes responsibility for communicating to markets how interest rates may move in future. In practice, it has thus far been a means of reassuring markets that rates will stay lower for longer.
Over the past 18 months, Carney has repeatedly changed his reasons for keeping interest rates on hold. Initially it was high unemployment, but when that improved faster than expected, he shifted the focus to low productivity and the number of part-time workers. By August 2014 it was the lack of wage growth, while most recently it is ‘the spectre of economic stagnation’ in Europe that delays any rate rise.
‘Forward guidance could have been a powerful tool,’ says Berenberg’s UK economist, Rob Wood, adding that ‘when first introduced, it was not obvious that the UK economy would recover so rapidly’. But the BoE has changed its guidance so often he now sees the policy as ‘dead in the water’. He adds: ‘There is no reason to place any weight on such guidance. They’ll just change their minds again if their previous stance seems inappropriate.’
Canada’s central bank recently dropped forward guidance, encouraging the markets to draw their own conclusions from inflation and other economic data. The US Federal Reserve has moved to a more flexible approach of interpreting data and communicating with markets. So has forward guidance gone out of fashion?
The reason for having forward guidance, according to Charles Goodhart, emeritus professor at the LSE and a former member of the BoE’s Monetary Policy Committee, is: ‘When the policy rate is close to zero, and you want to be more expansionary, the only mechanisms left for keeping long-term rates down are quantitative easing (QE) or forward guidance, which, at the moment, is telling everyone that the policy rate will remain lower for longer.’
In the immediate aftermath of the financial crisis, central banks slashed rates to near zero and resorted to unconventional measures to provide liquidity and stimulate growth. In Canada, according to Dr Mati Dubrovinsky, senior policy analyst at the C.D. Howe Institute: ‘Forward guidance seemed enough to do what the Bank of Canada saw as the target policy.’ Unlike the US or UK, Canada did not resort to QE.
Now that Canada’s policy rate is up to 1%, the Bank of Canada has some scope to cut it in order to stimulate growth, and therefore is not bound to forward guidance.
The problem with time-contingent forward guidance – as in stating that rates will not be raised for two years – is that the market can interpret this as implying the central bank thinks the economy will be weaker than markets expected. Goodhart says: ‘Central banks do not, as a rule, want to send out such messages. So they moved from time-contingent to state-contingent guidance, where any change to rates is linked to unemployment falling to a certain point or inflation rising above a given level.’
That would be fine if their own economic forecasts worked out. But as Goodhart points out: ‘Central banks, like most others, are pretty lousy at forecasting. Practically all of them got it wrong.’ Thus, when the BoE first adopted forward guidance, it was not expected that
unemployment would come down to the 7% target until 2016. That it did within nine months was good news, in that the economy was doing better than expected. But misplaced confidence in the BoE’s economic forecasting has dented its overall credibility.
So are there better ways of both guiding and reassuring markets? Federal Reserve chairwoman Janet Yellen has come up with the ‘dot plot’, a graph that shows where individual members of the Federal Open Market Committee expect interest rates to be at each year-end through to 2017.
Berenberg’s Rob Wood praises the Fed for being more direct in its pronouncements. ‘There are advantages in Yellen’s dots,’ he says, principally that they allow analysts to extrapolate which way policymakers’ views on interest rates are moving. Others disagree, because very different conclusions can be drawn from the graphs. ‘The Fed’s dot system has been a mess,’ says Goodhart, ‘and has confused everyone.’
Because of the dominance of the US economy, there is also the question of how far other nations are able to take a line truley independent of the Fed. ‘We see a lot of discussion of the independence of smaller economies or mid-sized central banks,’ says Dubrovinsky. Those that went against the trend, as when Sweden’s Sveriges Riksbank raised rates to counter house price inflation, have since had to reverse their policy.
And now there is the prospect of ‘currency wars’ versus the dollar, with the European Central Bank and Bank of Japan seeking to drive down their currencies (as well as stimulating growth) through expansionary policies.
‘Exchange rates matter,’ says Wood, ‘especially in an open economy like the UK. If sterling rose sharply, then it would push down on inflation, which is already low.’ But he finds ‘no evidence that forward guidance has achieved that much. All that it does is reiterate that the BoE expects rises in interest rates to be gradual once they begin,’ which is ‘not so much guidance as a restatement of what everyone already believes’.
Goodhart agrees that ‘in normal circumstances, we would retreat from forward guidance as market expectations are as good a guide as any’. Yet, while interest rates remain close to zero, he argues it still has a role – especially when markets are volatile.
‘Dovish statements from the majority in the Monetary Policy Committee do reinforce market expectations that rates will be held down for a relatively long time.’
Where the opinions of third parties are offered, these may not necessarily reflect those of St. James's Place. The opinions expressed are subject to market or economic changes.