BNP Paribas Asset Management explores the current landscape around forward guidance, focusing on how central banks’ methods of communication are likely to evolve in the future. By Richard Barwell
Alan Greenspan, the American economist who served five terms as the 13th chair of the US Federal Reserve, once remarked, perhaps in jest: “Since I’ve become a central banker, I’ve learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.” Times have moved on. Clarity of communication is seen as a virtue, not a vice, and forward guidance – discussion around the future path of policy – is seen as an important weapon in the central banker’s armoury. This article reviews the current state of play on forward guidance and discusses how central bank communication is likely to evolve in the future.
Why talk at all?
We need to understand the reasons central bankers talk about policy if we want to discuss how central bankers should talk.
The most important reason for communicating is accountability. Central bankers are unelected officials who wield considerable power. It is essential they publish an accurate and comprehensive description of their actions so elected representatives of the people can hold them to account.
Beyond accountability, communication can serve an important role in helping central bankers achieve their objectives. The expectations of the policy stance of the future that will prevail give central bankers traction over financial markets and the real economy, not the current stance. Forward guidance offers central bankers the opportunity to guide those expectations of the future policy stance and reduce uncertainty about the state of the economy and the policy process.
Classic forward guidance
Forward guidance must contain new information to move expectations. Central banks hold private information about the future stance of policy that may not be fully reflected in the expectations of private sector agents. That private information includes insights and analysis on the current structure and state of the economy, which inform the central bank’s forecasts of where the economy is headed. But it also includes a deep understanding of how the policy stance responds to economic developments – known as the reaction function. Releasing that information can reduce uncertainty about the state of the economy or the policy process.
The news in central bank communication typically involves the disclosure of private information on the structure and state of the economy, typically in the form of forecasts about the future path of growth and inflation. The extent to which those forecasts shift expectations of the policy stance will depend on the extent of the revealed disagreement (how much the market and the central bank disagree on the evolution of the economy), the perceived competence of the central bank (how much faith the market has in the ability of the central bank to collect and process information to arrive at an informed view on the state of the economy), and the perceived reaction function (how a revised view on the trajectory of the economy translates into a revised view of the policy stance).
Central bankers typically discuss the reaction function when trying to correct a perceived misunderstanding in the market. Essentially, the news (for the audience) is that the reaction function has not changed and central bankers describe how policy is likely to evolve given a particular economic outlook, under an unchanged reaction function. Comments on the path of the policy rate itself are rare, at least where the largest central banks are concerned.
Central banks typically don’t publish macroeconomic forecasts beyond a three-year horizon, which creates a natural end-point for forward guidance on the policy rate. However, central bankers have made an exception when it comes to communication about the exit strategy from the lower bound, providing a calendar and state-contingent guidance on the timing of the first rate hike that could potentially stretch far beyond that horizon. For example, the reference to the inflation path in the European Central Bank’s (ECB’s) guidance on lift-off that was inserted in June 2018 may ultimately prove a barrier to raising rates for many years to come. At one point, the Bank of England went further and provided guidance on the pace of rate hikes beyond that point (“gradual”).
However, it is unclear how much news there is in forward guidance on lift-off in the absence of accompanying macroeconomic forecasts. If the central bank is unwilling to discuss the outlook for inflation beyond three years, then any guidance linked to inflation beyond that point is inherently imprecise.
Backward-looking forward guidance
The classic reaction function is forward-looking. Policy depends on the current and expected future path of activity and inflation. Bygones are bygones in the sense that whether inflation was consistently too high or too low in the past has no bearing on the current policy decision (unless that history influences expectations today).
Policy-makers and academics have become increasingly concerned that the classic reaction function is no longer appropriate given the lack of policy space. Most central banks have already cut the policy rate close to the lower bound and accumulated massive bond portfolios. That leaves the global central banking community short on tools and are potentially unable to provide sufficient stimulus to the economy in the event of negative shocks. The economy could suffer frequent periods of high unemployment and low inflation, and that could ultimately lead inflation expectations to become unanchored from the downside. There are two solutions to the policy space problem that both work through forward guidance.
One is for the central bank to honestly disclose the scale of the problem and quantify the activity and inflation shortfalls in a given scenario. This message is bleak: the central bank acknowledges it is unable to achieve its mandate and that could prove counterproductive. The message could encourage expectations to de-anchor. The central bank might usefully supplement this guidance with an estimate of fiscal stimulus that is required to stabilise the economy in an effort to nudge the fiscal authority.
An alternative and more radical solution for a central bank that cannot provide enough stimulus today is to promise to provide too much stimulus in the future. The reaction function now becomes backward-looking. Policy-makers pledge to deliver too much inflation in the future to make up for too little in the past. The flexible form of average inflation targeting adopted by the Fed is a modest example of this strategy, with the Federal Open Market Committee pledging to deliver inflation “moderately above 2% for some time”. A stricter alternative is the commitment to achieve a price level path target that is consistent with delivering the inflation target so any undershoot is reversed in full.
In theory, this radical form of communication can have a powerful impact on expectations of the future path of policy. In practice, the effectiveness of the forward guidance may be compromised by a lack of credibility, given the familiar time inconsistency problem. The policy-makers who deliver the message may feel obliged to stick to the new reaction function, but their successors may find it easy to renege on the commitment. Moreover, if the guidance is incomplete or imprecise, then that can provide additional cover for policy-makers to renege.
The logical conclusion for policy-makers keen to shift expectations in this way is to invest as much personal and institutional reputation in the communication, and craft the forward guidance with as little flexibility as possible to maximise the perceived costs of reneging. Careful consideration should also be afforded the merits of holding regular strategy reviews, which provide obvious break points at which the central bank can renege on any shift in the reaction function that was communicated in the interim.
Guidance on outcomes
The forward-guidance debate has typically focused on communication about the future path of rates. However, quantitative easing (QE) has become increasingly important as an instrument of policy, and guidance needs to reflect that.
The analogue of the policy rate under an orthodox approach to QE is the quantity of money printed or, equivalently, the size of the asset portfolio. Which assets the central bank purchases with that cash also matter: for example, Treasury bills are a lot closer substitutes for cash than a long-term corporate bond. Forward guidance in this setting therefore involves communication on the likely flow and composition of new purchases and the reinvestment policy that governs the fate of the asset portfolio.
In practice, forward guidance in this arena has tended to be quite vague. In early March, the ECB announced it would significantly increase the pace of asset purchases for the next three months, but with no guidance on by how much or what happens after three months. In late April, the Fed’s chair, Jerome Powell, was only willing to confirm it was not the right time to talk about tapering the Fed’s QE programme.
The Bank of Japan’s (BoJ’s) adoption of yield curve control (YCC) in 2016 has prompted a reappraisal of the conduct of QE, which has implications for the modalities of forward guidance. Under YCC, the focus shifts from quantities to prices. The BoJ has a target for long-term bond yields and adjusts the pace of bond purchases to deliver that target. The ECB’s current guidance of preserving favourable financing conditions is far less precise – there is some detail on the assets concerned, a little detail on their relative importance and none on the price targets – but the focus is still on anchoring asset prices.
This shift from quantities to prices is welcome. Monetary policy has always worked through financial conditions, and this shift in QE strategy has therefore nudged forward guidance towards focusing more on outcomes (what level of financial conditions the central bank wants to deliver) and less on actions (how it plans to achieve that outcome). Moreover, forward guidance on outcomes has the appealing feature of encompassing all instruments and not just asset purchases.
Complete forward guidance
Central bankers are no longer mumbling with great incoherence, but the current approach still falls far short of full disclosure. The limiting case – what can be thought of as complete forward guidance – entails the central bank publishing all relevant private information. Central banks are likely to come under pressure to move in this direction.
Complete forward guidance starts with a comprehensive discussion of the outlook for all policy instruments. Publishing the optimal path for each policy instrument that policy-makers consider will deliver the best possible outcomes for output and inflation (given their imperfect understanding of the economy) and that are placed within probabilistic statements about the range of possible outcomes. The information is then supplemented with an analogous and overarching statement about outcomes: an optimal path for the desired trajectory of financial conditions placed within an appropriate range.
Complete forward guidance involves publishing the analysis and information that underpins those views, which includes quantitative analysis of alternative scenarios and policy responses, and a comprehensive description of the sequencing and pace of any exit strategy from the current stance. Publishing the central bank’s assessment of the current structure of the economy – with a particular focus on key features of the economy such as the location of the lower bound, the slope of the Phillips curve or the expected path of the equilibrium real interest rate – would certainly help demystify the policy process. Full disclosure also means describing the loss function that ultimately enables policy-makers to select the optimal path from the alternatives that are presented to them.
Monetary policy is typically set by committees, so complete forward guidance also requires each policy-maker to publish their own assessment of each aspect of the policy debate.
Monetary policy works through expectations. If a central bank concludes that those expectations are out of line with fundamentals, then it will likely perceive the prevailing level of financial conditions to be inconsistent with delivering price stability. The risks of misunderstanding are high, particularly as the moment of exit from the current loose stance approaches. Subtle hints about what central banks might do in the future are unlikely to solve the problem. The solution is complete forward guidance.
Richard Barwell is head of macro research at BNP Paribas Asset Management, responsible for promoting collaboration between investment teams and formulating alpha-generating investment views across all asset classes. Based in London, he joined BNP Paribas Asset Management in August 2015, prior to which Richard was a senior European economist at the Royal Bank of Scotland (RBS) markets and international banking; a senior UK economist at RBS global banking and markets; and a senior economist at the Bank of England. He has 18 years of investment experience and holds a BSc degree in economics and econometrics from the University of Nottingham, an MSc degree in mathematical economics and econometrics, and a PhD in labour economics, both from the London School of Economics and Political Science.
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