“Forward with forward guidance!” OR “Much ado about nothing?

Many central banks in advanced economies have engaged in some form of forward guidance. The latest to tread this path was the Bank of England, which was preceded by the Reserve Bank of New Zealand, the Bank of Japan, the Fed, the Norges Bank, the Sveriges Riksbank, the Czech National Bank, the Bank of Canada and the European Central Bank. Also the Swiss National Bank has lately, if somewhat implicitly, had recourse to forward guidance.

Table 1.  Different variants of forward guidance

Adoption Year	Description	Type of forward guidance
Central Bank
1997 RBNZ	Forecast of the 90 days bank bill rate path:  “We expect to maintain this stance until we can be confident that, after an easing, inflation would still turn down towards the middle of the target range in a clear and sustained manner.” [March 1997]	Soft (open ended)
1999 BOJ.1	Commitment to the zero policy rate decision from April 1999 to August 2000: “Bank to explicitly convey to the market its intention to maintain the current zero interest rate policy until deflationary concerns were dispelled ” [April 1999] [1]	Soft (open ended)
2001 BOJ.2	Threshold guidance tied to CPI, between March 2001 and July 2006 [2]: “To prevent a deflationary spiral, it would be appropriate to express the Bank's policy duration commitment as "until the CPI (excluding perishables) registered stably a zero percent or an increase year on year." [March 2001]	Threshold
2003 FED. 1	Implicit forward guidance between Aug 2003 and Nov 2005: “The Committee believes that policy accommodation can be maintained for a considerable period." [August 2003]	Soft (open ended)
2005 Norges Bank	Forecast of key policy interest rate path and confidence interval: “There are prospects that the key policy rate will remain at the current level, or somewhat lower, in the year ahead” [July 2013]	Time based
2007 Sveriges Riksbank	Forecast of the future path of policy rate; confidence level; commitment to maintain the level for specified periods: “Executive Board decided to keep the repo rate unchanged at 1 per cent. Slow increases in the repo rate are not expected to begin until the second half of 2014.” [July 2013]	Time based
2008 CNB	Forecast of key policy interest rate path and confidence interval: “Changes in the conduct and communication of monetary policy (also contain) disclosure of the forecast-consistent Interest rate path in numerical form, as a fan chart”  [February 2008]	Soft (open ended)
2008 FED	Implicit forward guidance from Dec 2008 to Jun 2011: “the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some [3] time” [December 2008]	Soft (open ended)
2009 BOC	Commitment to maintain key policy interest rate at low levels, for specified periods and conditional on the outlook for inflation: “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” [April 2009]	Time based
2011 FED.3	Calendar guidance from August 2011 to November 2012: “The Committee currently anticipates that economic conditions are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013 [4].” [August  2011]	Time based
2012 FED.4	Threshold guidance tied to unemployment, since December 2012: “The low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 (…)” [December 2012]	Threshold
2013 BOJ.3	Commitment to reach price stability objective, 2% CPI year-on-year change: “Under the price stability target, the Bank will pursue monetary easing  and aim to achieve this target at the earliest possible time” [January 2013]	Threshold
2013 SNB	Commitment to maintain the cap on the CHF in hopes of warding off deflation and recession: “The SNB stands ready to enforce the minimum exchange rate, if necessary, by buying foreign currency in unlimited quantities, and to take further measures, as required.” [June2013]	Soft (open ended)
2013 ECB	“Soft guidance”, tied to economic developments and compliant with the inflation objective: “The Governing Council confirms that it expects the key ECB interest rates to remain at present or lower levels for an extended period of time.”  [July 2013]	Soft (open ended)
2013 BOE	Threshold guidance, tied to unemployment: " the MPC intends not to raise Bank Rate from its current level of 0.5% at least until the Labour Force Survey headline measure of the unemployment rate has fallen to a threshold of 7%,” subject to the defined “ Knockouts”      [ August 2013]	Threshold

As can be seen in the table, like inflation targeting, forward guidance comes in different customized variants and there are some variants that are undistinguishable from normal central bank announcements, which do not really deserve a special name like “forward guidance”. It is thus useful to provide criteria to distinguish the different types.

One criterion to classify the different types of forward guidance is to distinguish those that:

•  Are time based;
•  Are threshold based;
• Do not have either an explicit time- horizon or threshold.

Another criterion to classify different types of forward guidance is to consider whether they change the reaction function of the central bank or whether they stress the central bank´s forecast of some variables that enter into its reaction function. If you formalize the central bank reaction function as: r= f (x0) [6] where r is the policy interest rate (or some other tool available to the central bank, e.g. the size of its balance sheet), f is the form of the reaction function and  x0  is the vector of economic variables which enter the reaction function, forward guidance can either change f or give the central bank reading of x0 , plausibly different from the market reading. If the reaction function is in the specific form of a Taylor rule [7] with    

then the former type of forward guidance would consist in a change of the inflation gap parameter α or  the income gap parameter β or both, but possibly also of the target levels of inflation and growth (π0 and y0)

Given the widespread recourse to forward guidance from central banks and the different guises in which it comes, two policy questions naturally arise:

1. What is new with forward guidance? Are we seeing a technological innovation in monetary policy making as important as inflation targeting and should we encourage central banks to go “Forward with Forward guidance” or do we have rather a case of “Much ado about nothing?”
2. Are the characteristics of forward guidance as classified above important in determining their effectiveness or could we say that the kind of forward guidance adopted does not necessarily determine its effectiveness?

 An example relating to the European Central Bank can help making the first policy question more precise. The ECB has a clear mandate, keeping inflation below but close to 2% over the medium term, and one can say that this mandate implicitly defines a forward guidance: do not raise interest rates until inflation is seen overstepping the 2% level in the medium run and lower it if it is expected to move too far below the target. Given that the currently available inflation projections for the euro-area do not indicate that inflation will exceed 2% at least until Q4 2015 (according to professional forecasters), the forward guidance implicit in the ECB mandate indicates that rates will not be increased until 2015, unless one would think that there is something of a kink in inflation projections after that date. So, one could argue that the words of the ECB President did not add much to the forward guidance implicit in the ECB mandate. Let me further address this issue only after having examined the second policy question, i.e. whether the form of forward guidance matters.

In principle, a forward guidance that changes the reaction function ( f in the notation above) should be more effective (in terms of changing market expectations) than a forward guidance that only told to the market that the central bank reading of the economy (as summarised in x0) is  different from that of market participants. However, in my assessment, only the case of forward guidance by the Bank of Japan in 2013 clearly implies an announcement of a change of reaction function, while the case of the FED in 2013 is somewhat ambiguous in this respect. In any case, it is my assessment that the small increase of the inflation threshold in the case of the Fed and the Bank of England, from the “normal” 2.0% to an “exceptional” 2.5%, is too weak to configure by itself a change in the reaction function.

A cursory look at the existing literature and the sketch of event study reported in the annex can throw some light on the question whether the form of forward guidance matters: which changes in the yield curve have taken place after the announcement of forward guidance by the different central banks?

Overall the results indicate that it is difficult to identify forms of forward guidance that work and forms which do not work. Thus the “soft” guidance of the Bank of Japan in 1999 and of the FED in 2008 seem to have had an effect. This was also the case, however, for the harder forms of guidance of the Bank of Japan and of the FED in 2001 and 2011 respectively. Instead, the threshold based forward guidance of the Bank of England seems not to have had much effect, like the softer form used by the ECB. The problem seems to be that, in order to send information to the market, the central bank would have to issue a precise and unconditional commitment, but messages of this kind have costs both in terms of comprehensiveness, because of concentrating attention on one particular variable, and flexibility, in making it difficult to react to unforeseen economic developments. Witness, in the latter respect, the difficulties of the FED that has communicated a specific level of the unemployment rate as threshold but has some problems in taking into account changes in the participation rate that impact on the assessment of the unemployment rate as an indicator of the state of the economy. Consider also that both the FED and the Bank of England felt the need to make their message conditional and less precise by adding inflation and, in the case of the Bank of England, financial stability as “knock-outs” for their forward guidance formulated in terms of unemployment rate. Overall, the soft or hard form of forward guidance does not seem relevant to surpass the difficulty of sending a precise and unconditional message.

Coming back to the first policy question that I put aside above, i.e. whether forward guidance is an important breakthrough in monetary policy technology and central banks should proceed “Forward with forward guidance” or whether it is more a case of “Much ado about nothing”, my sense is that it is easy to exaggerate the importance of forward guidance with respect to an earned credibility in pursuing the statutory central bank objective. This conclusion is reinforced by the fact that, in order to be effective, forward guidance should be precise and unconditional, but this, as argued above, has a cost and therefore it is difficult to go for very precise and unconditional formulations of forward guidance. At the end, the conclusion of Benoit Coeurè[8] that forward guidance belongs more to the communication than to the policy domain seems to be justified. Forward guidance, in conclusion, is much less of a substantial innovation that inflation targeting was decades ago.

ANNEX - Impact of forward guidance

Regarding the FED, as reported in the table in the text, there have been four episodes that can be considered, broadly speaking, as forward guidance. As seen in chart 1, the announcement in August 2003 (indicated as FED.1 in the table in the text) had no visible effect either on bond yields or swap rates. In the chart an effect is instead visible both for FED.2 in December 2008 and for FED.3 in August 2011, when the FOMC announced that rates would be kept close to zero at least until mid 2013. According to Swanson and Williams (2013), this produced a rate fall (8bps for the 2 year Treasury note and 20 bps for the 5 and 10 year notes) equivalent to 100 bps federal funds rate cut in normal times, when the ZLB was not an issue. In fact, the Treasury rate yields have been fairly stable up until July 2013, when the first announcement of tapering was made, in line with the initial forward guidance.

Chart 1: Treasury yields (left panel) and USD swap forwards (right panel)

When a numerical threshold for unemployment was announced in December 2012 (FED.4), no change was noticed in the USD Swap Forwards, but this is not surprising as the Fed Chairman stressed that the change from a date to an unemployment threshold in forward guidance did not imply a change in the projected path of interest rates.

BOE’s recent forward guidance announcement would imply keeping the key policy rates at low levels until Q3 2016. However, when looking at the Sonia rates, it seems market participants are pricing in a rate hike as early as 2015.  One possible interpretation is that market participants expect inflation to rise beyond the BOE forecasts and thus the inflation knockouts to come into play earlier than expected by the BOE. The same message is derived looking at Gilt yields as well as swap forward rates, as the path continues to steepen (see chart 2) despite the central bank’s announcement.

Chart 2: Gilt yields (left panel) and GBP Swap forwards (right panel)

A message similar to that relating to the Bank of England is obtained looking at the market reaction after the ECB announcement, as Euro swap forward rates as well as yields on German government bonds (Chart 3) have been also on the rise over recent weeks. In fact, many market participants have noted that the initial impact on the money market rates after the July meeting has quickly faded. Some market participants have noted that the rise in money market rates has to do with the lowering liquidity volumes[9] and that the ECB should consider other VLTROs if further easing should be needed.

Chart 3: German euro area yields (left panel) and EUR Swap forwards (right panel) 

 In the case of BOJ’s, the announcements in 1999 (BOJ.1) and 2001 (BOJ.2) seemed to have an effect on swap rates, indeed for these episodes, Okina and Shirasuka (2003) argued that the commitment to keep interest rates low was successful in stabilizing future path of short term interest rates. The forward guidance of 2013 (BOJ.3) seems, instead, to have had only a very temporary effect on government bond yields but not on swap rates.

Chart 6: Japanese bond yields (left panel) and JPY Swap Forwards (right panel)

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References:

E. Swanson, J. Williams: Measuring the Effect of the Zero Lower Bound On Medium- and Longer-Term Interest Rates, January 2013, Federal Bank of San Francisco Working Paper Series;

M. Raskin: The Effects of the Federal Reserve’s Date-Based Forward Guidance, May 20013, FEDS Working Papers;

J. Campbell, C. Evans, J. Fisher, A. Justiniano: Macroeconomic Effects of FOMC Forward Guidance, March 2012;

M. Del Negro, M. Giannoni, C. Patterson: The Forward Guidance Puzzle, May 2013, Federal Reserve Bank of New York Staff Report.

C. Kool, D. Thornton: How Effective is Central Bank Forward Guidance?, December 2012, Federal Reserve Bank of St. Louis Working Paper Series;

K. Okina, S. Shiratsuka: Policy Commitment and Expectation Formations: Japan’s Experience under Zero Interest Rates, June 2003, IMES Discussion Paper Series.

S. Shiratsuka : Size and Composition of the Central Bank Balance Sheet: Revisiting Japan’s Experience of the Quantitative Easing Policy, November 2009, IMES Discussion Paper Series;

K. Ueda : Deleveraging and Monetary Policy: Japan since the 1990s and the United States since 2007, July 2012 revision, CIRJE Discussion Papers;

*** Unconventional Monetary Policies-Recent Experience and Prospects, April 2013, International Monetary Fund;

*** Monetary policy trade-offs and forward guidance, August 2013, Bank of England;

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[1] This Post was prepared with the capable assistance of Mădălina Norocea.

[2] Message conveyed to the markets not as a policy directive but as a press statement by Governor Hayami.

[3] Although the Bank of Japan was no longer committed to the 0 rate and it noted that the year-on-year rate of change  in CPI  was to follow a positive trend, it mentioned that “accommodative monetary environment ensuing from very low interest  rates will probably be maintained for some time” depending on the assessment of the economic outlook.  From October 2009 the Bank adopted a change in language “The Bank will maintain the extremely accommodative financial environment for some time by holding interest rates at their current low levels”

[4] Replaced with “extended period” since 18 March 2009;

[5] Later changed with “late 2014” in January 2012 and “mid 2015” in September 2012;

[6] I owe this useful criterion to classify different types of forward guidance to Fabio Noacco, senior analyst at Mediobanca. A similar criterion was used by P. Praet, who took up the distinction between Odyssean ( f )
 and Delphic (x0) component of forward guidance [Peter Praet, Forward guidance and the ECB, August 2013]

[7]  Where r is the nominal policy rate; r0 the real policy interest rate; π0 the target inflation rate; π the actual inflation rate;  y0 the target output; y actual output.

[8]  Interview available at LeMonde.fr

[9] Daluiso and Papadia, in Can the ECB control interest rates?, explore the link between excess liquidity and money market rates to illustrate what they call the risk of „endogenous tightening“ given by the ability of commercial banks to return to the ECB their excess liquidity.