Cen­tral banks' 'for­ward guid­ance' prov­ing a tricky pol­icy tool

The Pak Banker - - COMPANIES/BOSS -

Words don't al­ways come easy for the world's cen­tral bankers, as Mario Draghi was re­minded last week. Af­ter first wow­ing mar­kets at his March 10 news con­fer­ence with a big­ger-thanex­pected eas­ing pack­age, the Euro­pean Cen­tral Bank pres­i­dent then mud­dled the mes­sage with a seem­ingly off­hand re­mark that rates may have bot­tomed out. Mar­kets even­tu­ally calmed, but the re­ac­tion to his com­ment was the lat­est il­lus­tra­tion of how cen­tral banks' com­mu­ni­ca­tions, in par­tic­u­lar "for­ward guid­ance", can go wrong, and ex­plains why some are al­ready back­ing away from this rel­a­tively new tool.

Cen­tral banks have long de­pended on com­mu­ni­ca­tion to guide or warn mar­kets: note for­mer Fed­eral Re­serve Chair­man Alan Greenspan's warn­ing about "ir­ra­tional ex­u­ber­ance" to ex­press cau­tion about the dot-com bub­ble or Draghi's prom­ise in 2012 to do "what­ever it takes" to pre­serve the euro.

But for­ward guid­ance can be an es­pe­cially pow­er­ful tool be­cause it sig­nals pol­icy in­tent, some­times years into the fu­ture, re­as­sur­ing or warn­ing house­holds and cor­po­ra­tions about the fu­ture path of in­ter­est rates. The re­sult is a nu­anced form of com­mu­ni­ca­tion that can have an im­me­di­ate pos­i­tive ef­fect on mar­kets but also eas­ily lead to more con­fu­sion than clar­ity and pos­si­bly mis­fire al­to­gether. "It's not a prom­ise, it's a best guess. It can't be too de­tailed and it can't be a prom­ise. In the worst case it can be con­fus­ing," said Ana­toli An­nenkov, an econ­o­mist at So­ci­ete Gen­erale.

For the ECB, the dif­fi­culty around last week's meet­ing may also sig­nal big­ger is­sues with man­ag­ing ex­pec­ta­tions, sev­eral in­sid­ers told Reuters.

Af­ter more than a year of rel­a­tively short in­ter­vals be­tween stim­u­lus pack­ages, con­tin­u­ous ac­tion has come to be seen as the norm at the ECB, plac­ing the bur­den on the bank to avoid dis­ap­point­ment. "Ev­ery time the Gov­ern­ing Coun­cil meets, the think­ing is: what are we go­ing to do next? Mon­e­tary pol­icy can't be this in­ter­ven­tion­ist per­ma­nently... we need to com­mu­ni­cate this bet­ter," a source fa­mil­iar with the bank's think­ing said. Draghi won cred­i­bil­ity at the height of the sov­er­eign cri­sis with his bold prom­ise to pre­serve the euro. But his prob­lems are very dif­fer­ent now, with the ECB bend­ing over back­wards to lift prices and ward off de­fla­tion.

The bank needs to bet­ter com­mu­ni­cate that it is flex­i­ble about how much time is needed to get in­fla­tion back to its tar­get, a source at one of the euro area's 19 cen­tral banks said.

"Re­solv­ing some shocks takes longer than oth­ers and we need to high­light that the time com­po­nent within the in­fla­tion tar­get is not ab­so­lute but de­pends on the in­fla­tion shock."

Widely used only since the fi­nan­cial cri­sis, for­ward guid­ance has been seen as a way to in­flu­ence mar­ket ex­pec­ta­tions with­out im­ple­ment­ing ac­tual poli­cies, es­pe­cially at a time when con­ven­tional tools are nearly ex­hausted.

De­vel­oped more than a decade ago in places like Swe­den and New Zealand, for­ward guid­ance can ei­ther pub­licly com­mit to fu­ture ac­tion -- or in­ac­tion -- or pre­dict eco­nomic per­for­mance and a likely mon­e­tary pol­icy re­ac­tion at a spe­cific time. But when the re­al­ity turns out dif­fer­ently, banks of­ten have to back­track, erod­ing their cred­i­bil­ity.

Bank of Eng­land Gov­er­nor Mark Car­ney, a cham­pion of for­ward guid­ance, es­sen­tially aban­doned the tool this year af­ter pre­vi­ous steers were knocked off course by the plunge in oil prices and in­fla­tion, earn­ing him the ep­i­thet of "an un­re­li­able boyfriend" from a mem­ber of par­lia­ment.

First, he linked the pos­si­bil­ity of a rate hike to the job­less rate, only to see the la­bor mar­ket re­cover much more strongly than ex­pected, forc­ing the BoE to bin that strat­egy. He then raised the prospect of a rate hike in 2014 and 2015, but the global econ­omy has slowed and Bri­tish wage growth re­mains stub­bornly slow. Fi­nan­cial mar­kets are cur­rently pric­ing in no in­crease in bor­row­ing costs un­til next year.

In Jan­uary, Car­ney merely promised to "do the right thing at the right time" on in­ter­est rates. The Fed has also pulled back from mak­ing ex­plicit for­ward guid­ance af­ter pre­vi­ously sig­naled rate hikes were de­layed. It now in­sists that moves are "data de­pen­dent", al­low­ing it more flex­i­bil­ity.

Traces of for­ward guid­ance re­main, how­ever, in the so-called "dot plot" pub­lished ev­ery three months which shows in a graph what in­di­vid­ual Fed board mem­bers and pres­i­dents pro­ject will be the ex­pected path of rate hikes over time.

The Fed's last dot plot sug­gested four hikes this year but mar­kets ex­pect just one at most, leav­ing a huge gap be­tween pro­jec­tions and ex­pec­ta­tions, even if the Fed changes the plot at its meet­ing this week.

"What's wor­ry­ing me is that ... it (the dot plot) looks like a com­mit­ment, it looks like a freight train," St. Louis Fed Pres­i­dent James Bullard said re­cently. Fed Gov­er­nor Jerome Pow­ell de­fended the in­clu­sion of dates in the plot, given that the Fed ex­pects rates to "only grad­u­ally" re­turn to pre­cri­sis lev­els. "Try say­ing that with­out re­fer­ring to time," Pow­ell said.

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