BANK of England governor Mark Carney’s colours are firmly attached to the forward guidance mast. Following broad hints on 4 July, next month the Bank is expected to formally adopt the practice of signalling the future path of monetary policy. Forward guidance, however, is likely to fail.
In a speech entitled Monetary Policy After The Fall, delivered in Alberta on 1 May last year while he was still governor of the Bank of Canada, Carney described three generations of forward guidance – qualitative, calendar-based, and based on thresholds for unemployment and inflation. He claims credit as the pioneer of calendar-based guidance by the Bank of Canada in April 2009, although this distinction properly belongs to the Bank of Japan.
Carney returned to the subject of interest rate guidance last December, defending its use as a way of providing extra monetary stimulus when at the “zero lower bound”. However, the financial landscape has altered dramatically since then. In December, tapering – the planned reduction in the pace of large scale asset purchases by the US Federal Reserve – was a twinkle in chairman Ben Bernanke’s eye. Indeed, the resumption of US Treasury bond purchases by the central bank under QE3 did not begin until the following month. While Carney may feel the same about forward guidance today as he did last December, the bond markets plainly do not.
Since 22 May, when Bernanke’s tapering whispers began, UK five-year government bond yields have risen from 0.82 per cent to 1.36 per cent, mirroring the increase in comparable US bonds from 0.89 per cent to 1.49 per cent. The new reality is that the tapering train has left the station and no amount of arm-waving by central bankers will send it back. In answer to questions at a conference in Massachusetts on Wednesday, Bernanke reaffirmed the tapering message, saying that things could have been much worse if the Fed had kept silent on its plans for winding down the programme.
To understand why global bond markets have seemingly over-reacted to the Fed’s signals, it is necessary to understand the importance of policy-dependent market positioning. As central banks have migrated along the spectrum from unanticipated interest rate changes to scheduled rate and asset purchase policy changes, investors have become emboldened to take huge risks along the yield curve.
The weight of leveraged positions in government bond markets associated with commodity trading advisers (CTAs) and risk parity funds, among others, helps to amplify central bank signals. Central bankers have only themselves to blame: they have harnessed the power of leveraged bond investment in the quest for ultra-low interest rates. They should not be surprised at the outcome when they send even the mildest of signals in the opposite direction. Bruised by the recent encounter with tapering, such investors will be in no hurry to put those risky trades back on, regardless of a UK announcement on forward guidance.
There are other objections to forward guidance that must be considered. First, it is a creature of the academic world of models and paradigms, not the realm of practical financial experience. These same arcane models proved utterly useless in the context of the global credit crisis. Second, the promises made by the central bank to maintain a near-zero policy interest rate into the future must be credible in order to have an impact. It begs the question, posed by James Bullard of the St Louis Fed, “why should future monetary policy deviate from normal once the economy is growing and inflation is rising?”
A third problem with policy pre-commitments on interest rates is that of pessimistic signalling. If the whole point of forward guidance is to persuade households and businesses to spend and borrow more, how can this be squared with the underlying policy assumption that the economy will not recover? While guidance based on outcomes for the unemployment rate and inflation forecasts may alleviate some of the problems with calendar-based guidance, the basic criticisms remain valid.
Can the Bank of England, or indeed the European Central Bank, send the message of lower-for-longer domestic interest rates when the Federal Reserve has sent a conflicting message? I venture not. The apparent success of US forward guidance in suppressing bond yields in the maturity range of one to five years between May and October 2012 was opportunistic. Financial markets have a rosier outlook today than they did last summer, and judge the Fed’s impending tapering both credible and appropriate. Forward guidance would be a backward step.
Peter Warburton is director of Economic Perspectives and a member of the Institute of Economic Affairs’s Shadow Monetary Policy Committee.