What “forward guidance” is, and how it (theoretically) works
Central bankers hope to reassure markets by saying what might influence policy in future
By R.A. | LONDON
IN DECEMBER 2012 Ben Bernanke, then chairman of the Federal Reserve, reached deep into the central banker’s bag of tricks and pulled out something novel. Using a new trick which became known as “forward guidance”, the Fed declared that it would not raise interest rates until America’s unemployment rate dropped to at least 6.5%, so long as inflation remained below 2.5%. In August 2013 the Bank of England followed suit. Mark Carney (pictured), its governor, promised to leave rates low until unemployment was down to at least 7%—again, so long as inflation and financial markets remained well behaved. In both America and Britain, unemployment fell quickly toward the thresholds. Yet neither central bank reacted by moving to boost rates, leading critics to argue that forward guidance had failed and should be scrapped. Central banks are instead tweaking their guidance: the Bank of England will update its guidelines on February 12th, and the Fed may soon do the same. What is the aim of forward guidance, and how is it supposed to work?
The goal of monetary policy is to smooth out macroeconomic wobbles by co-ordinating market expectations. Central banks want companies to be bullish enough to invest and hire willing workers, but not so exuberant that inflation begins to pick up. For most of the past generation, central banks performed their co-ordinating task by fiddling with short-term interest rates. Lower rates encourage more borrowing and signal that the central bank would like a faster pace of growth; higher rates encourage saving and tell markets to calm down. So severe was the global financial crisis, however, that even reducing interest rates to their lowest feasible level, near zero, failed to get growth back on track. Accordingly, central banks have since sought to influence the economy through other tools. “Quantitative easing”, or printing money to buy assets like government bonds, is one of the new, unconventional policies. Forward guidance is another.
Put simply, forward guidance is the use of communication about future central bank actions to influence present behaviour. If a central bank can convince markets that it will leave interest rates low for quite a while, allowing a faster recovery in the future than it might normally tolerate, then investors have an incentive to start investing more in the present so as to reap the benefits of that future bonanza. This sort of guidance actually predates the global crisis. In the late 1990s the Bank of Japan aimed to escape its economic doldrums by promising to leave interest rates at zero “until deflationary concerns subside”. And in 2003, when the Fed cut rates to 1% to shore up a weak recovery, it advised markets that policy would probably stay easy “for a considerable period”. In the wake of the global recession, central banks have experimented with new twists on forward guidance, such as the use of specific unemployment- and inflation-rate thresholds, to try to boost its potency. (After some initial confusion, central bankers now emphasise that such thresholds are necessary but not sufficient conditions for intervention.) By providing markets with more information about the type of recovery they would like to see, central banks hope to reassure investors that good times are ahead, and that regulators won’t immediately move to rein in the recovery at the first sign of market enthusiasm.
There is, no doubt, plenty of scope to improve and refine the technique of forward guidance. The latest fiddling is part of a long-term effort by central banks to improve communication about policy goals and methods. Over the past few decades they have gone from refusing even to share information about interest-rate decisions to setting official inflation targets, publishing meeting transcripts and releasing detailed forecasts for economic activity. To get the most bang for their buck, however, central banks will need to resolve the long-running argument over what monetary policy should be trying to achieve. Many central bankers continue to see low and stable inflation as the only reasonable goal for policy, while others argue that inflation moderately above target is an acceptable price to pay for a stronger recovery. (Still others think central banks should worry less about inflation and unemployment, and more about financial stability.) So long as priorities remain unsettled within central banks, forward guidance will remain somewhat vague—and a less powerful tool than it could be.
