A primer on forward guidance
Last week’s European Central Bank (ECB) and Bank of England policy (BoE) announcements, while not changing interest rates or other “unconventional” monetary policy tools like quantitative easing, have been interpreted by market observers as true game changers in how both central banks handle their monetary policy.
Both central banks have implicitly or explicitly started using forward guidance as a new tool. The BoE did so implicitly, acknowledging that Chancellor of the Exchequer George Osborne has asked the BoE’s Monetary Policy Committee to investigate forward guidance involving “intermediate thresholds” and respond in its next three-monthly inflation report scheduled for August.
ECB President Mario Draghi was more explicit. He said in his statement, “…looking ahead, our monetary policy stance will remain accommodative for as long as necessary. The Governing Council expects the key ECB interest rates [including the depo rate he was keen to point out] to remain at present or lower levels for an extended period of time.” He then pointedly snubbed a journalist who challenged him about change in ECB policy by saying, “If you ask that question, you didn’t really listen to my statement.”
So what is forward guidance all about and what has really changed? First one must acknowledge that there are two types of forward guidance: one is time dependent, and the other depends on economic variables and thresholds to which a central bank responds with action.
The Federal Reserve, making this difference clear, adopted an explicit forward guidance for the first time in its monetary policy statement of March 2009, when it acknowledged that Fed fund rates would remain “at 0 to 1/4 percent at least until mid-2013.” This time-dependent forward guidance was extended in January 2012 to “at least to late 2014” and then again in September 2012 to “at least to mid-2015.” By December 2012 the Fed decided to switch from time dependency to economic-threshold dependency, stating that the “exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”
Mario Draghi’s comment for the time being is clearly time-dependent forward guidance, while what Chancellor Osborne has in mind corresponds more to economic threshold-dependent forward guidance.
A second distinction on the nature of forward guidance relates to how markets interpret it. In what is probably the most in-depth investigation today on the Fed’s forward guidance since the start of the financial crisis, Federal Reserve economist Jeffrey Campbell and three of his colleagues have coined the terms Odyssean forward guidance and Delphic forward guidance. The latter describes how a central bank assesses its own forecasts for an economy and how it intends to react within its own policy rules. The former term is seen as a hint that a central bank, having the same knowledge on the state of the economy as the market, might break its own policy rules to change the pace of that economy.
Within this framework, forward guidance can also be seen as a game between two players, the central bank and the market, trading information about the state of the economy. The central bank moves first, and the market reacts. But in the game context, cheating, or more politically correct time inconsistency might occur, i.e. the central bank offers forward guidance but ultimately deviates from it. Former ECB President Jean-Claude Trichet alluded to this when he commented on the latest ECB decision: “Forward guidance is always conditional because nobody can think for one second that you would hesitate to move rates in any direction if there is a case to do that.”
But if it boils down to that, then the journalist snubbed by Mario Draghi was ultimately right. Nothing has really changed. Forward guidance is just old wine in new bottles. Central banks will continue to surprise markets and observers will continue to second guess them.