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ANALYSIS
T
he governor of the Bank of England (BoE), Mark
Carney, was an enthusiastic advocate of forward
guidance when he took office in mid-2013. Indeed,
he had been a pioneer of this approach since 2009
as governor of the Bank of Canada. By adopting
forward guidance, the central bank takes responsibility for
communicating to markets how interest rates may move in future.
In practice, it has thus far been a means of reassuring markets that
rates will stay lower for longer.
Over the past 18 months, Carney has repeatedly changed his reasons
for keeping interest rates on hold. Initially it was high unemployment,
but when that improved faster than expected, he shifted the focus to
low productivity and the number of part-time workers. ByAugust
2014 it was the lack of wage growth, while most recently it is‘the
spectre of economic stagnation’ in Europe that delays any rate rise.
‘Forward guidance could have been a powerful tool,’ says
Berenberg’s UK economist, RobWood, adding that‘when first
introduced, it was not obvious that the UK economy would
recover so rapidly’. But the BoE has changed its guidance so
often he now sees the policy as‘dead in the water’. He adds:‘There
is no reason to place any weight on such guidance.They’ll just
change their minds again if their previous stance
seems inappropriate.’
Canada’s central bank recently dropped
forward guidance, encouraging the markets
to draw their own conclusions from inflation
and other economic data.The US Federal
Reserve has moved to a more flexible
approach of interpreting data and
communicating with markets. So has
forward guidance gone out of fashion?
The reason for having forward guidance, according to Charles
Goodhart, emeritus professor at the LSE and a former member of the
BoE’s Monetary Policy Committee, is:‘When the policy rate is close
to zero, and you want to be more expansionary, the only mechanisms
left for keeping long-term rates down are quantitative easing (QE) or
forward guidance, which, at the moment, is telling everyone that the
policy rate will remain lower for longer.’
In the immediate aftermath of the financial crisis, central banks
slashed rates to near zero and resorted to unconventional measures
to provide liquidity and stimulate growth. In Canada, according
to Dr Mati Dubrovinsky, senior policy analyst at the C.D. Howe
Institute:‘Forward guidance seemed enough to do what the Bank
of Canada saw as the target policy.’ Unlike the US or UK, Canada
did not resort to QE.
Now that Canada’s policy rate is up to 1%, the Bank of Canada has
some scope to cut it in order to stimulate growth, and therefore is not
bound to forward guidance.
The problem with time-contingent forward guidance – as in stating
that rates will not be raised for two years – is that the market can
interpret this as implying the central bank thinks the economy will
be weaker than markets expected. Goodhart says:‘Central banks do
not, as a rule, want to send out such messages. So they moved from
time-contingent to state-contingent guidance, where any change to
rates is linked to unemployment falling to a certain point or inflation
rising above a given level.’
That would be fine if their own economic forecasts worked out. But
as Goodhart points out:‘Central banks, like most others, are pretty
lousy at forecasting. Practically all of them got it wrong.’Thus, when
the BoE first adopted forward guidance, it was not expected that
unemployment would come down to the 7% target until 2016.That it
did within nine months was good news, in that the economy was doing
better than expected. But misplaced confidence in the BoE’s economic
forecasting has dented its overall credibility.
So are there better ways of both guiding and reassuring markets?
Federal Reserve chairwoman Janet Yellen has come up with the‘dot
plot’, a graph that shows where individual members of the Federal
Open Market Committee expect interest rates to be at each year-end
through to 2017.
Berenberg’s RobWood praises the Fed for being more direct
in its pronouncements.‘There are advantages inYellen’s dots,’ he
says, principally that they allow analysts to extrapolate which way
policymakers’ views on interest rates are moving. Others disagree,
because very different conclusions can be drawn from the graphs.
‘The Fed’s dot system has been a mess,’ says Goodhart,‘and has
confused everyone.’
Because of the dominance of the US
economy, there is also the question of how
far other nations are able to take a line truely
independent of the Fed.‘We see a lot of
discussion of the independence of smaller
economies or mid-sized central banks,’ says
Dubrovinsky.Those that went against the trend,
as when Sweden’s Sveriges Riksbank raised
rates to counter house price inflation, have
since had to reverse their policy.
And now there is the prospect of‘currency wars’ versus the
dollar, with the European Central Bank and Bank of Japan seeking to
drive down their currencies (as well as stimulating growth) through
expansionary policies.
‘Exchange rates matter,’ saysWood,‘especially in an open economy
like the UK. If sterling rose sharply, then it would push down on
inflation, which is already low.’ But he finds‘no evidence that forward
guidance has achieved that much.All that it does is reiterate that the
BoE expects rises in interest rates to be gradual once they begin,’
which is‘not so much guidance as a restatement of what everyone
already believes’.
Goodhart agrees that‘in normal circumstances, we would retreat
from forward guidance as market expectations are as good a guide as
any’.Yet, while interest rates remain close to zero, he argues it still has
a role – especially when markets are volatile.
‘Dovish statements from the majority in the Monetary Policy
Committee do reinforce market expectations that rates will be held
down for a relatively long time.’
Balance sheet
Bank of England governor Mark Carney has long been a fan of
forward guidance; but with the policy seemingly falling out of fashion, economic
commentators feel there are better ways of reassuring the markets.
Misplaced confidence
in the BoE’s economic
forecasting has dented
its credibility
THE INVESTOR
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