The final verdict on the usefulness of forward guidance will depend on how central banks navigate the final stages of the economic recovery and whether they can return to normal monetary policy after years of extraordinary accommodation, according to an article in the latest quarterly review by the Bank for International Settlement (BIS).
In a roundup of the evidence on the effectiveness of forward guidance, two BIS economists find reduced volatility of near-term expectations about future policy rates, suggesting that major central banks - the Federal Reserve, the Bank of Japan, the Bank of England and the European Central Bank - have been successful in clarifying their intentions to financial markets and investors.
But in the longer term, the effects on interest rates and the responsiveness of financial markets is more mixed and not very systematic in one direction or the other, according to Andrew Filardo, head of monetary policy at the BIS, and Boris Hofmann, senior BIS economist.
“At the same time, the forward guidance raises a number of significant challenges. How they are managed will ultimately determine the enduring value of this communication tool,” they conclude.
Forward guidance has been a key element of monetary policy at the zero lower bound since 2008, with the major central banks employing various forms of guidance about future policy.
Guidance has taken various forms: Qualitative, as used by the ECB; calendar-based, as used by the Fed from 2011 to 2012; or threshold-based, as currently used by the BOJ.
The BOJ was the first major central bank to adopt forward guidance 1999 at the so-called zero lower bound. The zero lower bound describes the situation when a central bank has already cut interest rates to effectively zero and cannot cut further.
The intention with forward guidance at the zero lower bound is to provide additional stimulus by communicating that policy rates will remain lower than is priced into markets or reduce uncertainty among investors, thereby lowering interest rate volatility and possibly also risk premia.
But forward guidance has to be credible, it must be clearly communicated and then interpreted in the manner intended by the central bank, elements that raises significant challenges.
These challenges include the risk to central banks’ reputation and the risk to financial stability from a central bank recalibrating its guidance.
If a central bank uses calendar-based forward guidance, a deviation in a projected timetable due to economic changes could be perceived as the central bank reneging on a commitment, potentially undermining its credibility.
Using state-contingent guidance, such as an unemployment rate, can ease the appearance of a central bank reneging on a commitment, but it raises the risk that the central bank is seen to be shifting away from controlling inflation. This was a frequent comment in the press when the BOE last August adopted an unemployment threshold.
Examining the economic evidence of forward guidance on financial markets shows an immediate impact of announcements on the level of future interest rates, but with some signs that the impact diminishes over time.
However, the BIS economists call for caution when interpreting the results as they don’t take into account existing market expectations and possible delays. The declining impact, for example, may reflect an improved ability of markets to anticipate the actions of the central bank over time.
Another complication is that forward guidance announcements have often coincided with news about asset purchases or other policy changes, making it difficult to draw strong conclusions about the relative effectiveness of different types for forward guidance.
“We conclude that the recent increased reliance on forward guidance has been helpful in clarifying policy intentions in highly unusual economic circumstances. However, the mixed evidence concerning the effectiveness of these practices, and the challenges they raise, caution against drawing firm conclusions about their ultimate value,” Filardo and Hofmann said.
Click to read the March 2014 issue of the BIS Quarterly Review.
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