September 19, 2013 6:42 pm
The snags in forward guidance are starting to show
The monetary policy fad is being undone by the element of surprise
Investors have, this week, been shocked because of so-called forward guidance – the latest vogue in monetary policy, whereby central bankers set out their plans months or years in advance so that lenders and borrowers know what is coming. The reason for their surprise is that it emerged that the US Federal Reserve’s forward guidance did not actually mean what it appeared to have said.
Until this week, when the Fed announced it would not yet start reducing the pace of its monetary stimulus programme, forward guidance had a good record. Canada has enjoyed enviable performance since the financial tsunami hit the world in 2008. Some would say it benefited from ample raw materials. But it owes something to the policy of Mark Carney, the former Bank of Canada governor who took over at the Bank of England in July.
Because Canada did not have state-contingent threshold-based guidance during this period. It had “time-contingent guidance”, which is very different: a pledge not to tighten policy before a preappointed moment. The state-contingent variation has existed in the US only since last December and in the UK since July.
Bigger issues are at stake than teasing Mr Carney. Monetary policy was on hold in many countries, including the UK, from the onset of the Great Depression for a good 20 years. During that time the load had to be borne by fiscal policy. There were several reasons for the comeback of monetary policy. Officials had a gut feeling that, as inflation was a disease of money, it had to be fought by monetary policy. This opened the question of whether slumps were also a monetary disease.
But these questions are too metaphysical for a September Friday morning. The deciding factor – certainly among politicians – was the idea that monetary policy was more flexible than the fiscal variety. It could be changed at any time without waiting for Budgets.
So has Mr Carney thrown away this flexibility with his forward guidance? No. The MPC has agreed not to raise bank rate from its present 0.5 per cent, at least until unemployment has fallen from its recent 7.7 per cent to 7 per cent, after which its hand would be free. Nor does it intend to reduce the stock of assets it purchased under the quantitative easing scheme. This is hardly recklessly loose. I cannot help noting that unemployment was well below 7 per cent even in recessions during nearly all the postwar period, except for spells in the mid-1980s and early 1990s.
The guidance itself is subject to important qualifications – which Mr Carney calls “knockouts” – when it would not apply. The first applies if the MPC regards it as likely that the inflation rate will be 0.5 percentage points or more above the official 2 per cent target 18-24 months ahead. Inflation has only once been below this threshold for any full year since 2008. But monetary doves can relax: the forward guidance knockout applies to BoE forecasts, not actual inflation rates.
The second knockout is if inflationary expectations cease to be “well anchored”; I take this to mean if the inflation rate implicitly forecast by the gilts market starts to take off. The third knockout is if there is a threat to monetary stability that cannot be contained by non-monetary actions. This can mean anything the BoE wants it to mean; but I assume it applies if any large bank is thought to be in danger.
The fuss in the US this week has arisen because investors placed too much weight on the fine detail of the forward guidance in predicting monetary policy and too little on real-world economic conditions. It is tempting to agree with Brian Reading of Lombard Street Research that UK policy will be tightened when unemployment is low and inflation high and kept loose when the reverse applies. But how low is “low” and how high is “high”? The MPC does provide a little help here, but we are not further forward on understanding monetary policy than a good textbook should suggest. Alas, there is a shortage of textbooks that are of much practical help here.
Even if such textbooks did exist, forward guidance would help consumers pick up information from media reporting. So a case can be made for forward guidance Carney-style as an educational exercise. But, as the Fed has shown, if forward guidance seems to change midstream, that can leave everyone more confused than if we all just assumed monetary policy responded to events as they happened.
Copyright The Financial Times Limited 2013.
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