In memory of Dr. Andreas Höfert

Forward confusion

| Tags: Andreas Höfert

Allow me to revisit my skepticism of forward guidance, the new fad among central banks. They now use this communication tool to steer market expectations, but I have my doubts how usefully.

Last September after the Federal Reserve thwarted market expectations by announcing that it would not start exiting its third round of quantitative easing (QE3), Stanley Fischer, former thesis advisor of Fed Chair Ben Bernanke and potential candidate to follow him as chairman, stated, “You can’t expect the Fed to spell out what it’s going to do. Why?
Because it doesn’t know. We don’t know what we’ll be doing a year from now. It’s a mistake to try and get too precise. […] If you give too much forward guidance you do take away flexibility.”
Fischer’s critique, expressing a humility not widely shared in the economic profession, aims in first instance at the time-dependent forward guidance. Bernanke made the mistake back in May of announcing the Fed’s intention to start tapering later in the year. A majority of market participants interpreted this forward guidance to mean that the first tapering would occur in September.
When Bernanke didn’t correct those expectations during the summer, he surprised market participants by not doing anything in September, since the conclusion was foregone. Time-dependent forward guidance is tricky, but so is data-dependent forward guidance. After the Fed’s decision in September not to taper, Bernanke remarked that market participants had misinterpreted his forward guidance, which was not bound to a specific moment in time but to economic numbers. Was he arguing in bad faith? Let’s give the Fed chairman the benefit of the doubt.
In June Bernanke said that once the tapering starts “we expect to continue to reduce the pace of purchases [of assets] in measured steps through the first half of next year, ending them around midyear. At that point, if the economy had evolved along the lines we anticipated, the recovery would have gained further momentum, unemployment would be in the vicinity of 7 %.”
So if we interpret this correctly, QE3 should be finished once the unemployment rate reaches 7%, which was its level in November. But by November 2013, the exit of QE3 hadn’t even started. Back in June the Fed was apparently forecasting that the 7%-level in the unemployment rate would only be reached by mid-2014. Obviously, the Fed forecasts were wrong.
But here we again get an excuse from the Fed. Market participants shouldn’t look only at the unemployment rate, but at the overall situation on the labor market as expressed by the participation rate, or the entries and exits from that market. Knowing that currently the participation rate on the US labor market is 63%, while it was 67% before the 2007/8 financial crisis, the Fed indeed has reason not to hasten the exit of QE3…
…until one reads a Fed study published in November. In it, Shigeru
Fujita, economist at the Federal Reserve of Philadelphia, concludes that “the decline in the participation rate in the last one-and-a-half years [i.e. since the first quarter 2012] (when the unemployment rate declined faster than expected) is entirely due to retirement.”
If we read this correctly, then the situation on the US labor market doesn’t seem as bad as the Federal Reserve is suggesting when it explains why the tapering didn’t start in September.
Forward guidance is the central bankers’ new tool. At least in the US so far, it doesn’t seem to work optimally – maybe because the tool is new and needs a running-in period or maybe because the idea of forward guidance itself is flawed. Too much transparency might ultimately create more confusion than clarity.