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Friday 25 October 2013

In defence of forward guidance

Although this post is prompted by the bad press that the Bank of England’s forward guidance has been getting recently, much of what I have to say also applies to the US, where the policy is very similar. But there is one criticism of the policy in both countries that I agree with which I will save that until the end.

A good deal of the criticism seems to stem from a potentially ambiguity about what the policy is designed to do. The policy could simply be seen as an attempt to make monetary policy more transparent, and I think that is the best way to think about it in both countries. However the policy could also be seen as a commitment to raise future inflation above target in an attempt to overcome the ZLB constraint as suggested by Michael Woodford in particular [1]. Let’s call this the Woodfordian policy for short. (John Cochrane makes a similar distinction here.)  Ironically the reason why it helps with transparency is also the reason it could be confused with the Woodfordian policy.

In an earlier post written before the Bank of England unveiled its version of forward guidance, I presented evidence that might lead those outside the Bank to think that it was just targeting 2% inflation two years out. We could describe that as the Bank being an inflation forecast nutter, because it gave no weight to the output gap 2 years out. An alternative policy is the conventional textbook one, where the Bank targets both inflation and the output gap in all periods. I suggested that if the Bank published forward guidance, this could clearly establish which policy it was following. It has and it did: we now know it is not just targeting 2% inflation 2 years out, because it says it will not raise rates if forecast inflation is expected to be below 2.5% and unemployment remains above 7%. 2.5% is not hugely different from 2%, but in the world of monetary policy much ‘ink’ is spilt over even smaller things.

So forward guidance has made things clearer, as long as you do not think monetary policy is trying to implement a Woodfordian policy. Unfortunately if you really believed a central bank was an inflation forecast nutter, then you could see forward guidance in Woodford terms. Now I think there are good arguments against this interpretation. First, 2.5% is an incredibly modest Woodfordian policy. Second, for the US, there is a dual mandate, which would seem to be inconsistent with being an inflation forecast nutter. Third, for the UK, the MPC has made it pretty clear (most recently here) that it is not pursuing a Woodfordian policy. For all these reasons, I think it is best to see forward guidance as increasing transparency.

For those who just want to know whether monetary policy changes represent stimulus or contraction, this can be confusing. We saw this in the UK with the questioning of Mark Carney by the Treasury Select Committee, and Tony Yates has pursued a similar theme. Mark Carney kept saying that the stance of monetary policy is unchanged, but forward guidance makes monetary policy more ‘effective’. Now you could spend pages trying to glean insights into disagreements among the MPC from all this, and I do not want to claim that the Bank is always as clear as it might be here. However it seems to me that if the Bank wants for some reason to call reducing uncertainty increasing effectiveness, then there is nothing wrong with what Carney is saying. Forward guidance helps agents in the economy understand how monetary policy will react if something unexpected happens. In particular, growth could be stronger than expected (UK third quarter output has subsequently increased by 0.8%), but the decline in unemployment could remain slow (it fell from 7.8% to 7.7% over the last three months). Charlie Bean makes a similar case here. [2]

In much of the UK media forward guidance has been labelled a failure because longer term interest rates went up as forward guidance was rolled out. Now if you (incorrectly) see forward guidance as a Woodfordian policy, you might indeed be disappointed that long rates went up (although you would still want to abstract from other influences on rates at that time). However if it is about clarifying monetary policy in general, no particular movement in long rates is intended.

Ironically, some of the apparent critics of forward guidance in the UK, like Chris Giles here, also think the Bank of England could be much more transparent in various ways. The most comprehensive list is given by Tony Yates, and I agree with much of what he says. But we all know that central banks are very conservative beasts, and do things rather gradually. So any improvement in transparency is going to be incremental and slow. When they do happen, in this case through forward guidance, they should be welcomed rather than panned. Criticising innovation by central banks risks fuelling their natural conservatism.

This suggests that the major weakness with forward guidance is that it does not go far enough. In the current context, as events in the US have shown, the major problem is that it applies only to interest rates and not to unconventional monetary policy. This allowed the market to get very confused about what the Fed’s future intentions about bond buying are. So why not welcome forward guidance by saying can we have more please.  

[1] Gauti B. Eggertsson & Michael Woodford, 2003. "The Zero Bound on Interest Rates and Optimal Monetary Policy,"Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 34(1), pages 139-235. See also Krugman, Paul. 1998. “It’s Baaack! Japan’s Slump and the Return of the Liquidity Trap.” BPEA, 2:1998, 137–87.
[2] If you wanted to be pedantic, you could argue that to the extent that some thought growth might be faster than expected, and that this would lead to higher rates even if unemployment remained high, then dispelling this particular possibility must mean that averaged across all states of the world policy has become more stimulatory. Carney might not want to acknowledge that because some on the MPC would get upset. My reaction to this would be, why do you want to be pedantic. 


  1. "For all these reasons, I think it is best to see forward guidance as increasing transparency."

    That is roughly the same conclusion I came to when the Bank of Canada announced, in April 2009:

    "With monetary policy now operating at the effective lower bound for the overnight policy rate, it is appropriate to provide more explicit guidance than is usual regarding its future path so as to influence rates at longer maturities. Conditional on the outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010 in order to achieve the inflation target. The Bank will continue to provide such guidance in its scheduled interest rate announcements as long as the overnight rate is at the effective lower bound."

    The Bank thought the bond market was making an incorrect forecast about how quickly the Bank would raise rates, and wanted to influence the bond market by giving it more accurate information.

    Trouble is, if easier monetary policy is expansionary, we might expect long rates to rise on the announcement of easier monetary policy.

  2. Paul Krugman likes to say that no one in the general public cares about rates of government debt, and the polls prove it. And it looks now that no one in the general public cares about GDP either, as all the focus is on wage rises being far less than inflation.

    So if standard of living is the Big Issue, that is where a central bank should focus its efforts if it wants to be popular and proportionate.

  3. And popular should definitely not mean being chummy with the financial markets. After everything with Greenspan/Rubin, we now have someone over here ex-Goldman Sachs.

  4. "In much of the UK media forward guidance has been labelled a failure because longer term interest rates went up as forward guidance was rolled out...However if it is about clarifying monetary policy in general, no particular movement in long rates is intended."

    Could we say that one of the aims of unconventional monetary policy in general is to decrease real (rather than nominal) interest rates? This was the case e.g. both in Japan and in the US, where nominal rates increased in general following a new QE, but by less than anticipated inflation.

  5. As you suggest, guidance is less Woodfordian than widely presumed. First, in the case of the MPC, the post-guidance briefing indicated no time inconsistency. Second, in the case of the FOMC, their policy forecast appears to reflect an extremely depressed short-term neutral rate as opposed to some degree of time inconsistency - a point raised by Bernanke in the press conference (only normalizing in 2018/2019) and ehoed in the minutes (a "number" is more than a "couple"):

    In particular, if economic headwinds died away only slowly, as a number of participants expected, the achievement of the Committee’s employment and price stability objectives
    would likely require keeping the federal funds rate below its longer-run equilibrium value for some time even as economic conditions improved.

    A couple of participants also remarked that they viewed their projections of a low federal funds rate in 2016 as reflecting a commitment to support the economy by maintaining a
    more accommodative policy for longer.

    Of course 1. is not exclusive of 2. but the "tell" is the inflation forecast of the SEP, where with the exception of one "crazed" FOMC participant, all 2016 core PCE forecast are at or below 2%. It would be nice if they actually forecast above target inflation one of these days, perhaps then policy could be judged as appropriately stimulative.


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