Central banks rely on forward guidance

Ben Bernanke television

As interest rates remain low among developed economies, shaping expectations through communication is proving to be an effective monetary tool.

Communicating the taper

At its last monetary policy meeting, the U.S. Federal Reserve announced its intent to reduce the size of its bond purchases beginning in January. Known as “tapering,” this long-awaited move cut future monthly bond purchases from $85 billion to $75 billion. While the Fed has long argued that this reduction does not amount to a tightening of policy, markets have viewed it as a step toward a higher interest rate environment.

However, the policy statement from the December 17th-18th Federal Open Market Committee (FOMC) meeting complemented the taper with a substantial strengthening of its forward guidance on rates. FOMC members added a sentence stating, ‘The Committee now anticipates…that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6.5 percent.” Much of the concern over the taper had revolved around whether or not the path of asset purchases would affect the timeline for future rate hikes. With this new guidance, market participants could be relatively assured of the Fed’s intentions.

In addition, this amounted to an easing of policy. The threshold of 6.5 percent unemployment was previously set as a point when the Fed might consider changing rates, but no other qualitative information had been given on the Fed’s reaction function. This guidance committed the Fed to a low interest rate policy for longer by building in a window of time between crossing the threshold and the first-rate hike.

Building in expectations

The Fed has tinkered with its forward guidance as it has periodically struggled to convey its plans effectively. However, it is clear that the Fed considers its ability to change expectations through communication to be a stronger tool than the mere sum of monthly purchases. In the press conference after the FOMC’s meeting, Ben Bernanke told reporters that asset purchases were a supplementary tool to the main lever of rate policy.

As rates are still at the zero lower bound, that rate policy comes in the form of signaling about the future path of rates. Long-term interest rates are made up of the expected path of short-term rates plus premia (the added percent required to compensate for holding a security longer). If the Fed can actually move the market’s expectations, it can pull down long-term interest rates and help drive demand.

The Fed is not alone in believing that communication works well. Both the Bank of England and the Bank of Japan have joined ranks in providing more information to markets about their goals and how they plan to implement policy to get there.

Back in August, the new head of the BOE, Mark Carney, led the Monetary Policy Committee to indicate that its “highly stimulative stance” would be maintained until slack in the economy was reduced. Similar to the Fed, the BOE introduced a threshold of 7 percent unemployment, above which it would not contemplate lowering rates provided inflation did not go above 2.5 percent. The Bank of Japan kicked off “Abenomics” by precisely defining its goal of price stability to be an inflation rate of 2 percent. The BOJ hopes that by indicating that it will do everything it can to achieve 2 percent inflation, people will begin to “price in” a higher rate of inflation and hasten Japan’s attempt to escape deflation.

Flexibility or constraint?

Around the developed world, central banks are talking more but are making only slow economic gains. Most of this has to do with fiscal policy and headwinds from global market setbacks. However, the effectiveness of new monetary policy tools has been called into question by many commentators. Some have wondered whether the increased signaling has merely muddied the picture for market participants.

Yet, much of the policy making economic profession has bought into the concept of forward guidance. When that guidance actually aligns market expectations with policymakers’, it can be a powerful tool. As the Fed begins its march back to normalcy, the question is whether committing to a policy a year or two in advance leaves policymakers vulnerable. If the U.S. economy surprises and sustains an above average GDP growth rate with continued gains in employment, the Fed might find itself in a position where it wants to raise rates but can’t because of its prior commitments.

FOMC members view the end of 2014 as the earliest the U.S. will hit 6.5 percent and therefore peg 2015 as the likely year for rate increases. But FOMC members have been notoriously consistent in being off the mark in their predictions. Breaching their commitments in an upside risk environment would undermine the credibility of the bank and make future policy harder. As Janet Yellen takes the Chairmanship in February, she will have a complicated line to walk. However, given the direction that Fed has headed, she will probably be talking a lot about it.

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Categories: Economics, International

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