Forward misguidance
September 22, 2013 2:12 pm
by Gavyn Davies
The Fed’s actions last Wednesday created more outrage than usual from investors, some of whom clearly felt that they had been misled, inadvertently or not, by the FOMC’s botched attempts at forward guidance during the summer months.
Challenged at his press conference, Mr Bernanke said that he makes monetary policy for the good of the economy, not to ratify the expectations of investors. In this, he is fully justified. The fact that a minority of investors might have lost money as a result of the so-called “broken contract” should not concern the Fed one jot. Caveat emptor!
But there are more significant reasons why the Fed and other central banks should pay attention to the market’s reaction last week. It highlights difficulties inherent in their new and much-loved strand of policy, forward guidance.
Mr Bernanke said that the Fed believes that forward guidance on rates is now “stronger and more reliable” than asset purchases. Furthermore, his possible successor Ms Yellen was chair of the Fed committee which designed the current communications strategy. Her “optimal control” approach, committing to holding short rates below their normal level as the economy recovers, would place even more weight on forward guidance. If so, the FOMC really needs to get better at deploying it.
The attraction of forward guidance in present circumstances is fairly obvious. With short term interest rates at zero, and the size of the balance sheet almost maxed out, central banks have resorted to reducing long bond yields by promising to keep short rates lower for longer, expecting this to be reflected in the yield on the long bond. In general, this has worked rather well. But it does rely on persuading the markets to do what the Fed wants them to do, since the behaviour of asset prices is an important channel through which the policy is supposed to work. Therefore the markets cannot be ignored.
The well-known difficulty with forward guidance is that, when the time comes, the central bank may not want to deliver on its promise to hold interest rates down as inflation rises. It then has an incentive to renege on its promise, claiming that “circumstances have changed”. But the fact is that investors can see in advance that this incentive exists, so they will not necessarily believe the commitment in the first place. The whole strategy suffers from what economists call “time inconsistency”.
One way round this is for the central bank to build up a reputation for always doing what it says it is going to do. As a rule, the Fed has been very good at this. Its word has been both respected and feared in the markets. Lately, however, the Fed has become determined to be almost painfully transparent in its communications with the public, and this has led to problems.
Consider the latest episode on the tapering of QE. The groundwork for tapering was very carefully laid, starting in March when Mr Bernanke made a surprising speech, saying that the term premium in the bond market was too low. This was an early warning that some upward adjustment in yields was acceptable to the Fed, even though they were still buying $85 billion of long bonds each month. It was followed by increasingly explicit language in the summer, including start and end dates for tapering, and a suggestion that the unemployment rate was expected to fall below 7 per cent before QE would end completely.
On Wednesday morning, Mr Bernanke seemed to have the financial markets exactly where he wanted them, but then came the bombshell. If the Fed can appear so cavalier after spending so much time and credibility guiding expectations on this decision, why should we believe them next time?
All of the complexity surrounding these calendar dates, unemployment thresholds and inflation knock-outs was well meaning, but only succeeded in obscuring the Fed’s main point, which was that tapering would be data determined and would depend on there being a “substantial improvement in the outlook for the labour market in the context of price stability”. If the Fed has simply stuck to this formula, the scope for confusion would have been greatly reduced.
The Fed’s leadership no doubt believes that it has not misled anyone, and certainly its actions last week can be made to appear consistent with the precise language of its previous statements. In June, the Chairman clearly said that “our policy is in no way predertermined”, and “reductions in the pace of purchases could be delayed”. But that is not the impression he was seeking to give at the time. He cannot have it both ways: either he is giving meaningful forward guidance, or he is not.
People should not need a PhD in linguistics to understand what the Fed is saying. In a previous era, the Fed announced absolutely nothing after meetings of the FOMC, and Chairman Greenspan told a Congressional committee that “if I turn out to be particularly clear, you’ve probably misunderstood what I’ve said”.
This policy of deliberate misguidance has now been replaced by a policy of “over-guidance”. The more we say, the more they will have to believe us, is the new mantra.
Neither extreme seems optimal. The next Chairman of the Fed needs to reconsider the current approach, which is to overcome the problem of time inconsistency by hemming itself in with an ever-growing number of apparently explicit commitments (though wriggle room is always left in the fine print).
This may work for short periods, but it leads to a loss of credibility when the inevitable happens and some of these solemn commitments are jettisoned.
The credibility of the Fed is one of the most precious commodities which America possesses. Over time, breaking commitments is costly. If it insists on pursuing forward guidance, it could greatly simplify its message, along the following lines:
“We think that there is still a large margin of spare capacity in the economy, and currently we do not intend to raise short rates for several more years.”
It is very doubtful whether any central bank can usefully go much further than that.
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