Forward guidance in monetary policy is a deceptively simple idea. It aims to provide more information on the direction of monetary policy. Better understanding of central banks produces better results, the theory goes.
Guidance is also supported at the very top of central banking. “I have strongly supported this commitment to openness and transparency,” Janet Yellen, the US Federal Reserve chairman designate, said in her Senate confirmation hearing yesterday.
But since the summer, four problems have emerged.
First, things get tricky when circumstances change.
The minutes from the September Federal Open Market Committee highlight the anguish created inside a central bank. Some on the committee wanted to delay slowing the Fed’s asset purchases because the data had been “disappointing”, but others worried “a delay could potentially undermine the credibility or predictability of monetary policy”. This is a dilemma.
In Britain, the Bank of England designed its guidance for a world of stagnation with stubbornly high inflation but by the time it put it into action the economy was already strengthening and inflation falling. The BoE thought in August that its threshold for considering tighter monetary policy - when unemployment falls to 7 per cent - was likely to occur in mid 2016, but has had to bring forward the estimate to late 2014.
Do the new facts alter monetary policy expectations, Mr Carney was repeatedly asked on Wednesday. He was unable to answer, saying merely he wanted to “learn on this journey” towards lower unemployment.
Second, guidance does not always have the intended effect.
Before events had undermined the clarity of policy, the BoE’s forward guidance was in any case not working as intended. The bank thought its August commitment not to raise interest rates at least until unemployment fell to 7 per cent would alter market expectations, delaying the moment traders thought the bank would raise rates and thereby imparting a “more effective stimulus” to the UK economy. Albeit mildly, the policy’s introduction had the reverse effect on traders’ expectations.
Third, proxies often fail.
Even if markets had behaved as central bankers expected, the most troublesome aspect of forward guidance has been a failure of specific economic variables – the unemployment rate in the US and UK – to act as a good proxy for overall economic conditions.
In the US, falling unemployment has been caused as much by the jobless no longer seeking work as by an improving economy.
In the UK, three months after the BoE said the unemployment rate was the best proxy of slack in the economy, it is already wriggling away from the link.
Fourth, the commitments are paper thin.
There is evidence that although central bankers talk a lot about the merits of guidance, their hearts are not really in it.
Mario Draghi’s introduction of guidance to keep rates low for an “extended period” in July was not really a change in policy. “We will look at these three things, which is basically consistent with our two-pillar strategy and perfectly consistent with our reaction functions,” he said.
As far as the BoE is concerned, the detailed guidance explicitly does not prevent the central bank from raising rates if unemployment is above 7 per cent, nor is it forced to do so if it falls to the threshold.
Naturally, when challenged on the efficacy of guidance, bankers say that outcomes would be worse without the policy, although evidence to support such a claim is thin. Mr Draghi was more honest than most this month: “You are never sure whether it is your own forward guidance that is the determining factor or other factors.”
Uniquely among central banks, the BoE has encountered all four problems. That sounds serious for the credibility of the most venerable of central banks. But the BoE and Mr Carney are likely to escape with their reputations intact.
Why? Few complain when growth is running at an annualised rate over 3 per cent and inflation is finally coming back to target.
Copyright The Financial Times Limited 2013.