The Fallacies Of Forward Guidance
With the recent adoption of explicit forward guidance as a stimulative policy tool by the major European central banks, virtually every major central bank is now using the tool in some form. The potential benefits and dangers of such policies as central bank communications have evolved are unclear as "the form of guidance" matters. As Robin Brooks notes, and is so well illusrated below in the example of the Riksbank's and Norges Bank's 'failures', "[In terms of implications for rates] the jury is still out on how well forward guidance works. What is clear, though, is that markets prefer 'deeds' to 'words'."
Forward Guidance has become extremely important...
As Central bank communications (whether at extremes of policy or not) have evolved dramatically over the past 20 years...
(click image for massive legible version)
Especially intriguing is Janet Yellen's note:
As recently as two decades ago, most central banks actively avoided communicating about monetary policy. According to Janet Yellen, the current Vice Chair of the Federal Reserve who was recently nominated to succeed Chairman Bernanke: “Montagu Norman, governor of the Bank of England in the early 20th century, reputedly lived by the motto “never explain, never excuse”.
The conventional wisdom among central bankers was that transparency was of little benefit for monetary policy and, in some cases, could cause problems that would make policy less effective.
Source: Janet Yellen, Speech: “Communication in Monetary Policy”,
April 4, 2013.
We have little historical precedent for judging the efficacy if explicit forward guidance. However, as Goldman Sachs notes, Norway’s Norges Bank introduced a form of forward guidance in 2005, while Sweden’s Riksbank followed soon after in 2007; and so we look to how well their "guidance" has fit reality (or shaped markets at the time)...
Lessons From Forward Guidance Pioneers
Forward guidance is not a policy reserved for only extreme situations. Indeed, well ahead of the global financial crisis and before the “zero lower bound” of policy rates motivated some central banks to explore the role of communication tools to achieve further easing,
Explicit but conservative
The Scandinavian central banks’ form of forward guidance is among the most explicit in nature: both Norges Bank and the Riksbank publish a “policy rate path” several times a year detailing the level of the policy rate expected by the (majority) of the Executive Board of the central bank over their forecast horizon (around three years). In addition, the Scandinavian central banks publish a range of economic forecasts, such as growth, inflation, the output gap and the unemployment rate.
Although the form of forward guidance may be one of the most explicit currently in place, the nature is more conservative: the “policy rate path” is a conditional estimate of future policy rates - based on the economy and market conditions – not a commitment.
With no intention of attempting to “tie their hands” in the way that Fed-style forward guidance aims to do by promising to keep rates “lower for longer” than would normally be the case, Norges Bank and the Riksbank maintain full discretion at all times. Forward guidance in Scandinavia is therefore a pure communication tool rather than an innovation in monetary policy strategy.
Relevant for the ECB?
Scandinavian central banks’ lengthy experience with forward guidance may be more relevant for the ECB’s nascent forward guidance than what one might immediately think. While the ECB’s style of forward guidance is rather vague, stating only that policy rates will remain at current or lower levels for an “extended period of time”, compared to the Scandinavian central banks’ detailed policy rate paths, both the ECB and Norges Bank/the Riksbank maintain full discretion of their policy rates at all times.
This is a crucial similarity. And with a shared fundamental underpinning of forward guidance, the Scandinavian experience may shed light on whether a more explicit form of forward guidance by the ECB, while maintaining full discretion, might help the ECB more effectively influence Euro area money market rates.
Gains from transparency despite discretion
A look at how past shifts in the Riksbank’s published policy rate path have impacted market pricing suggests that changes to the policy rate path can be just as important to shaping forward market pricing as changes to actual policy rates. Because the form of communication at the Riksbank is so explicit, this experience provides a likely upper bound to what can be achieved (e.g., by the ECB) with a fully transparent form of forward guidance that still allows for full discretion.
While we do not expect the ECB to adopt much more explicit forward guidance, let alone to actually publish a policy rate path any time soon, the Riksbank experience suggests that the ECB’s impact on market rates may be enhanced by increasing the information available to the market regarding the ECB’s view of future likely policy developments. This could take the form of increasing the length of the ECB’s forecast horizon (currently only between 1 to 2 years) or providing a greater account of the Governing Council’s deliberations.
[ZH: While the result is still out, one thing seems very clear from the two charts above... Central bank "forward guidance" appears always and forever overly-confident of their ability (or willingness) to tighten...]
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