How can central banks improve forward guidance?
It is fair to say that forward guidance doesn’t enjoy a good reputation in the UK. The policy, introduced with some fanfare by Mark Carney on his arrival as Governor of the Bank of England, was meant to give greater clarity about the path of interest rates.
But its critics claim it just confuses households, investors and businesses because of a perception that the Bank keeps changing its mind. On this view, the Bank has too often guided people towards thinking monetary policy will go in one direction - only for it not to. This has led some critics to label Mr Carney as an “unreliable boyfriend”.
These critics suggest that the Bank could improve its forward guidance by providing more information. But more information does not necessarily lead to better-informed people. The Bank already publishes a lot. On so-called “Super Thursday” each quarter we get a 50-odd page inflation report, detailing the Bank’s new forecasts, alongside the minutes from its latest meeting on interest rates, all in one go. The Bank also uses everything from speeches to Facebook to explain its thinking.
More information could arguably even lead to greater scope for misinterpretation and misunderstanding
Investors in financial markets may study every nuance of these communications, but it’s doubtful whether the general public is equally vigilant. In a busy world, the average person probably takes the view that trying to analyse every twist and turn in the Bank’s thinking is not worth their time. So Mr Carney has argued that guiding people to expect a “limited and gradual” pace of monetary tightening at the present time is perfectly sufficient. More information could arguably even lead to greater scope for misinterpretation and misunderstanding, with firms and households behaving in ways counter to the Bank’s objectives.
Even so, other central banks do find arguably more creative ways to guide interest-rate expectations. The US Federal Reserve’s “dot plot”, where members of the central bank’s decision-making committee give their views on the path they think rates should take, is a good example. Financial-market investors certainly scrutinise it closely.
But it is subject to exactly the same charge of “unreliability”, since the dots tend to move around as the underlying economic data changes and committee members revise their views. Nordic central banks take another approach, providing more explicit guidance via forecasts of future interest rates. But again, these forecasts are subject to revision.
Nor should we think that scrapping forward guidance is the solution. This would mean returning to the kind of “constructive ambiguity” favoured by former Federal Reserve Chair Alan Greenspan. Such a radical move seems out of step at a time of demands for greater transparency and openness. And central banks themselves still believe firmly in at least attempting to help the average person understand their thinking.
Ultimately, the charge of unreliability may have more to do with a lack of realism about how much certainty central banks can provide in uncertain times. The Bank of England doesn’t know what the final outcome of Brexit or trade wars will be, or much else about the future for that matter. And yet it has to take a view, since the interest rate decisions it makes today take time to have their full impact.
As John Maynard Keynes said, “When the facts change, I change my mind. What do you do, sir?” Forward guidance only makes sense if the central bank accounts for how economic reality changes over time. Sticking rigidly to it could, for instance, mean the Bank raising interest rates even as an economic shock is clearly tipping the economy into recession, or cutting rates in the face of an unsustainable boom in the housing market.
As investors, we should be mindful that forecasting the future path of the economy in an uncertain world is extremely difficult – and it’s this fundamental truth that makes the Bank’s task so hard. Criticising the Bank’s forward guidance is easy. Providing genuine solutions to improve it is a much tougher challenge.
A version of this article was published in City AM on 2 August.
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