MARKETS RUN INTO FOG OF FORWARD GUIDANCE / THE FINANCIAL TIMES MARKETS INSIGHT

Markets Insight

Last updated: January 13, 2014 12:03 pm

Markets run into fog of forward guidance

By Satyajit Das

Central bank communication policy reveals lack of options

A paucity of policy options facing central bankers has increased reliance on forward guidance; an oxymoron as any guidance must be about future events.

In essence, the central bank communicates its commitment to future actions on interest rates, liquidity provision or quantitative easing over a medium to long-time horizon. The aim is to provide certainty and reduce volatility, providing businesses and investors with the ability to plan. However, the approach suffers from a number of weaknesses.

First, a focus on any single or a narrowly based set of indicators is problematic. The US Federal Reserve’s commitment to accommodative monetary policy was based on a target unemployment rate. A single indicator, devoid of context, is not meaningful.

Unemployment can be affected by participation rates or by its definition and calculation basis. Levels can be affected by unexpected disruptions like a government shutdown, strikes or natural catastrophes. The nature of employment – part- or full-time, the type of job or income levels – is relevant to policy. The composition of unemployment – temporary or long term, age and skill levels of the unemployed – may be pertinent.

The Bank of Japan’s policy targets 2 per cent inflation. It is not entirely clear which inflation indicator is the most relevant. Core inflation ignores the effect of volatile food and energy prices, which are important to Japan. Inflation in domestic goods or imported inflation, such as the result of currency movements, may have different policy implications.

Second, forward guidance relies on the accuracy of central bank or business forecasts to plan for the timing of announced actions. An unanticipated trigger event may lead to a sudden and sharp change in interest rate or monetary policy as the automatic rule-based central banking response occurs. This would create volatility and uncertainty, precisely the opposite of the policy objective.

Highly conditional

Third, guidance is highly conditional. Environmental changes can negate any earlier policy commitment. The US Federal Reserve was forced to clarify that its unemployment target was merely a non-binding indicator.

Fourth, as Citibank chief economist Willem Buiter has argued, central bankers have “no skin in the game”. Central banks do not stand to make or lose money from their forward commitments. Central bankers’ tenure or remuneration is also not linked to outcomes.

Fifth, the approach can also be compromised by inconsistency and conflicts among policy makers in an age of instant communications. Take, for example, the following exchanges.

On July 4 2013, European Central Bank President Mario Draghi said key ECB rates would remain “at present or lower levels for an extended period of time”. On July 6, ECB board member Benoit Coeure observed that “[forward guidance is] a change in communication but not in monetary policy strategy”. On July 8, Mr Draghi was forced to provide a clarification: “We’ll have to see what the market reaction has been, is and will be to this statement.”

On July 9, ECB board member Joerg Asmussen commented, “[The period] is not six months, it’s not 12, it goes beyond”. The ECB immediately issued a statement saying Mr Asmussen did not intend to give guidance on the exact length of time for which the ECB expects to keep rates at record lows.

On July 11, Bundesbank President Jens Weidmann resorted to classical allusion: “It is not an absolute advanced commitment of the interest rate path. The ECB Council has not, like Odysseus, simply tied itself to the mast.” On October 2, Mr Draghi cryptically alluded to “a vast array of instruments”, which remain unspecified.

Seeking to separate the signal from the noise, markets pine now for the clarity of former Fed chairman Alan Greenspan: “I know you believe you understand what you think I said, but I am not sure you realise that what you heard is not what I meant.”

Limited options

Ultimately, it will not be the words but the potency of central bank weapons and actions that will determine the impact on economic activity. With fiscal policy constrained and monetary policy stretched, the real problem is limited available options, with central banks forced to experiment with techniques of unknown efficacy and potentially toxic side-effects.

Increasing reliance on forward guidance is drawing unwanted attention to the limitation of central banking instruments and policy. To any casual observer, it resembles the unarmed English policeman in comedian Robin Williams’ sketch trying to apprehend a fleeing suspect with the exhortation: “Stop! Or . . . I’ll shout stop again!”

Satyajit Das is a former banker and author of Extreme Money and Traders Guns & Money

Copyright The Financial Times Limited 2014