Forward Guidance, a primer
Central bankers do not have an easy job at the best of times. They must work in a world of constant yet random shocks, imperfect models and political pressures, while trying to hit a moving inflationary target six months to a year down the line. All of this while working with a rather limited arsenal. Since 2008, central banks (CB) have used the interest rate as the primary tool to influence economic policy. Interest rates have approached, or in some cases even exceeded, the zero lower bound, with no sign of definite recovery. Drastic times call for drastic measures and central bankers have resorted to so-called unconventional monetary policy in order to provide additional monetary accommodation as a last resort. One such unconventional method termed “forward guidance” has been employed in one form or another by CBs around the world.
What is forward guidance?
Forward guidance (FG) is the practice of providing long-term forecasts for future interest rates. It is a method by which CBs can avoid excessive market volatility. It provides investors with a glimpse into what is referred to as the CB's “reaction function”. In other words, “how will the CBs policy instrument respond to macroeconomic conditions?” This reduces investor uncertainty, thereby decreasing the number of assets investors have to keep in order to compensate for that uncertainty. In theory, these excess funds can be used instead on other economic activities that should stimulate the economy.
The term forward guidance can technically be applied to any form of information regarding the future utilization of monetary policy instruments. The most common example of FG concerns the policy rate, also known as the short-term interest rate. There are many different forms of this type of FG, however they generally can be separated into two broad categories that have their origins in Greek mythology. The first type of FG is known as Delphic FG, named after the oracle at Delphi. Just like the oracle, Delphic FG is a prognostic gesture made by CBs regarding the future state of the policy rates over a non-specific time frame. This form of FG was practised by the Reserve Bank of New Zealand in the late 1990s as well as by Norges Bank during the early 2000s. A present-day example of this is the European Central Bank’s usage of the term “extended period of time” to describe the non-specific time frame.
A second type of forward guidance, dubbed Odyssean FG, is conditionally contingent or data dependent on macroeconomic variables such as unemployment or inflation. This form of FG is well-known in the post-crisis world. Examples include the United States Federal Reserve Bank’s goal of 6% unemployment and 2% inflation, or the Bank of England’s adoption of a similar FG model aiming at 7% unemployment. This state-dependent guidance predicates a tangible commitment by the central bank to hold rates low for a given time. This commitment is akin to Odysseus’ actions as he and his crew sailed by the Island of the Sirens in Homer’s ancient Greek epic poem The Odyssey. Just as Odysseus resisted the tantalizing song of the Sirens, so too must the CBs resist the temptation to raise rates no matter how temping it may be. Even in the face of uncomfortably high inflation, like Odysseus, the CB is tied to the mast and will sail through monetarily accommodative seas until it arrives at its destination—hence the name Odyssean FG.
However, there are problems with Odyssian data-dependent FG. Firstly, data may not accurately represent the situation. Secondly, assumptions about measurements such as the natural rate of employment are fragile at best. This is why CBs cleverly include escape clauses in their statements giving them flexibility even though their stipulations for rate increases have been met.
... Like Herding Cats
For FG to have a positive impact it must be believable, communicated unambiguously and interpreted with the original intentions of the CB. The first point usually takes care of itself: if the CB goes back on its commitment once, it will be hard to regain the public’s confidence regarding future promises. The effectiveness of FG can also be lessened depending on how it is interpreted by the public. For example, upon hearing that policy will be accommodative for a long time, the public may take it as a signal of the severity of the negative outlook. This can further constrict the economy—the opposite of what the bank intended. Further complications can arise from the mechanics of the CB’s decision: Was the decision made by many voters on the CB's board? Was it unanimous? Are there many dissenting opinions? These factors will undoubtedly impact the public’s reaction to rate forecasts.
Foward Guidance Effectiveness - Does it work?
There is a consensus that FG has indeed decreased uncertainty over the future path of rates, although this is hard to quantify since its effect is confounded by other factors. A number of studies have been released that have attempted to quantify the effect that FG has had in different national economies. The challenge many of these studies faced was how to separate the effect of FG announcements from other policy actions or news issued at the same time. For example, the U.S. Federal Reserve announced the next phase in its large-scale asset purchases program along with information about future federal funds rate paths in the same meeting statements. Other confounding factors, such as delayed effects, or action taken in anticipation of the announcement, make it difficult to identify the effects.
There are others who may agree that FG is useful at the lower bound to stimulate the economy further. However, continued FG usage when rates are high may cause more volatility. The governor of the Bank of Canada has made this point, explaining that during normal times FG should be avoided as it shifts too much of the interpretation of new information to the Bank, as opposed to letting markets conduct their own assessments. It is valuable to have markets that are able to cope with a degree of uncertainty. Last year, after the Fed’s communication concerning the tapering of the asset purchasing and the gradual raising of rates, many emerging markets witnessed large-scale bond sell offs. A resulting foreign exchange market crisis followed. It could be argued that this is a result of the volatility caused by FG.
CBs have gone from being inscrutable in the past to being relatively transparent today. They publish minutes of their policy meetings and give out as much information as possible to the public. This has allowed the public to form their own expectations about the future of inflation and policy. FG is one such tool that can affect expectations. The role of the public’s perceptions regarding monetary policy has been evolving ever since the discovery of the Philips curve. Policy tools such as forward guidance, will continue to evolve alongside with it.
Date: July 22, 2015
TagsSouth Africa oil prices USA Canada precious metals Italy Unemployment rate Sub-Saharan Africa Japan Gold Asia Africa Exchange Rate NAFTA IMF Emerging Markets Panelists MENA India Consensus Forecast Colombia Financial Sector Venezuela Russia Ukraine Economic Growth (GDP) Tunisia Energy Commodities Housing Market Base Metals Commodities Infographic Germany China Greece G7 Portugal Brexit Argentina Banking Sector Latin America United States Turkey Vietnam Agricultural Commodities Major Economies Investment OPEC UK Industrial Metals Commodities Commodities Oil Fed World Bank Eastern Europe Euro Area Forex Company News Precious Metals Commodities Spain Inflation Trade European Union Australia Mexico Brazil France Iran Nordic Economies
8 hours ago
23 hours ago
1 day ago
1 day ago
1 day ago
- Are uranium prices making a comeback?
- Taxing the Economy: Achieving a Delicate Balance
- Is the UK really "shackled to a corpse"?
- How will Latin America’s upcoming lengthy election cycle affect the reform agenda and credit ratings?
- How will emerging market economies perform in 2017?
- Chilean Economy in Focus: Interview with Senior Economist of the Chamber of Commerce of Santiago
- CEOs Rank Top Economies for Growth Opportunities
- The Mobile Ecosystem & Latin America's Economy
- Prospects and Challenges for the Global Economy: Interview with Tim Cooper from BMI Research
- How will the Fed reduce its balance sheet & and how will the ECB end QE? - 19 economic experts weigh in
- Thoughts on "unwinding" QE from Frances Coppola
- Gold: The Most Precious of Metals (Part 3)
- The Fed and ECB at a crossroads: Unwinding QE
- Spain: The economy that continues to silence the critics
- Latin America: The Most Unequal Region in the World
- The History of OPEC: Has it been a Success?
- FocusEconomics Announces 2017 Analyst Forecast Awards Winners
- Latin America’s rising unemployment bucks nearly decade long trend
- Escape from the Central Bank Trap by Daniel Lacalle
- China's economic rebalancing act: What to look out for in 2017
- Driving Growth in Latin America: Challenges & Priorities
- Is the Global Economy Rebalancing?
- Commodity exporters face challenging times
- Recent Global Events Facilitate Mercosur-Pacific Alliance
- 23 economic experts weigh in: Why is productivity growth so low?
- Mexico's outlook as Trump nears 100-day mark
- Interview with Oxford Economics Senior Economist on implications of the possible outcomes of the French Presidential Election
- The anxiety of the small saver in a world of negative interest rates
- Brexit negotiations. Between Uncertainty and Urgency
- An Economic History of the EU from El Blog Salmón
- Baby Boomin': Implications of high population growth in Latin America
- Survey of International Economists Predicts a Le Pen Defeat in French Elections, Says Macron has Best Economic Plan
- Spain in a global context: developed economy with some challenges
- How much is crime costing Latin America?
- Predictions & Estimates from Economist Daniel Lacalle
- What economy will the new Dutch government inherit?
- “The data is not a true reflection of reality in India” Interview with Société Générale India Economist
- 2017 & 2018 Economic Outlook for the Top Oil Producing Countries
- Which countries will have the highest and lowest inflation in 2017?
- What are the prospects for Emerging Economies in 2017?
- What to expect in Asia for 2017
- Top Economics & Finance Blogs of 2017
- Latam to Resume Moderate Growth in 2017 but Important Risks Plague Outlook
- 4 Key European Elections That Will Impact the Economy in 2017
- How are security concerns and political chaos affecting Turkey’s economy?
- Global growth to edge up in 2017
- Set to breach targets again? Debt and deficit outlooks for Southern European Eurozone countries in 2016 & 2017
- What does Donald Trump mean for the U.S. economy?
- How will emerging markets perform in 2017?
- The economic impact of a break in U.S.-Philippines ties
- Trump election: Base metals surge due to infrastructure plan
- 5 updates on the Venezuelan economic crisis
- Canada: When your neighbor’s house is on fire…
- Short-term pain before long-term gain? A look at French labor reform and economic growth
- Asia: Unremarkable growth & unfulfilled promises?
- How India's latest monsoon is affecting the economy
- Russian economy update in wake of OPEC deal announcement
- Innovation in Latin America: Potential Goes Untapped Due to Weak Economic Conditions
- The Wisdom of the Crowds and the Consensus Forecast
- Can the peso predict the U.S. election results?
- There's no end in sight to the Venezuela crisis
- A Look at the European Union Political Calendar
- Survey of international economists shows uncertainty surrounding elections damaging U.S. growth prospects
- FocusEconomics partners with leading online statistics provider Statista
- China: Recent postive economic data may be papering over the cracks
- Sub-Saharan Africa's 2016 & 2017 growth rates
- The Italian Dilemma: Weak banks pose risk to already faltering domestic demand
- How much money do migrants from Latin America send home?
- The U.S.' (Not So) Mysterious Case of the Missing Men
- What to expect from the G20 economies by 2020
- The Pain in Spain: Robust GDP growth cannot mask the persistent structural deficit