Over the last few months, Fed chair Janet Yellen has led a train of Federal System governors in guiding financial market expectations towards an interest rate “lift-off” at the central bank’s December meeting. This week, more than six years into an economic recovery, it finally happened – but how successful has forward guidance been?
As it played out, the market took the quarter point rise in short-term interest rates in its stride. But was forward guidance the right policy tool for the economic conditions of the past six months? Not in our view. Central banks are rightly fixated by policy credibility in the minds of price setters, planners and financial markets. It’s this credibility that maintains the grip of the key nominal anchors in markets and economies.
Perversely, however, forward guidance at the end of emergency monetary easing provides the wrong kind of anchor; it’s akin to a nervous parent who can’t let a child step out into the world on her own two feet. In times like these, the most credible policy is to allow markets to drag central banks, kicking and screaming, to raise rates – only then can we be sure that the market will withstand a hike.
Because what a central bank needs to know when exiting emergency policies is that the market will withstand higher interest rates. It cannot know this while still delivering continued reassurance through forward guidance. At the end of emergency easing, successful and credible central bank policy requires them to be “behind the curve”.
Here in the UK, forward guidance continues, but the execution has been messier. Events overtook Bank of England governor Mark Carney’s best laid plans twice in the last 18 months – most memorably when he reneged on his 2013 promise to raise rates based on future levels of UK employment. At the end of the day, central banks know no more about the future than any other experienced investor in the market. And so forward guidance can overly constrain the whole process of forming views about the future when events change, whether they be central bank views or market views.
The problem was more serious in the Eurozone, where European Central Bank president Mario Draghi set up market expectations for a significant expansion of quantitative easing in December. He didn’t deliver, causing the euro to strengthen 4 per cent and stock and bond markets to sell off in December. At one point, Germany’s Dax index was down 11 per cent that month.
From now on, we still have forward guidance, but the guidance is, effectively, opportunistic gradualism; and that is simply good old fashioned central banking. It can hardly be labelled an extraordinary policy tool: this has been the bread and butter of central banking for several decades. For the Federal Reserve and anyone interested in what it does (that should be all of us), it’s back to the normal business of watching the data. On that basis, Yellen has played a master stroke.