Central bankers backtrack on forward guidance

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New York and Tokyo - The world’s major central banks are returning to a more opaque and artful approach to policymaking, ending a crisis-era experiment with explicit promises that they have found risked their credibility and did not substitute for action.

The shift from transparency to flexibility underscores the challenges central bankers face as they test the limits of what monetary policy can achieve.

“Central banking used to be an art,” a senior official of a Group of Seven central bank said. “It became less so once, globally, but … it may be back to being an art.”

Central bankers have been chastened in the past year after some specific messages confused and disrupted markets.

The US Federal Reserve and Bank of England (BoE) promised to hold interest rates near zero until their unemployment rates fell to a particular level. But US and UK unemployment fell much more quickly than economists expected and both central banks scrambled to replace their suddenly outdated “forward guidance”.

“Too much transparency may sometimes be counter-productive. The balance is always tricky,” the official said.

The plan was novel. After driving short-term borrowing costs to historical lows to battle the 2007 to 2009 financial crisis and deep recessions, Western central banks began offering pledges on the future rate path in an attempt to pull down long-term borrowing costs.

Fed chairwoman Janet Yellen and other policymakers say the strategy succeeded on that score, although other factors contributed. But Yellen is leading the charge away from specific policy forecasts.

“The idea of forward guidance was that by being transparent, you got a bigger effect on long-term rates,” Patrick Artus, the global chief economist at French bank Natixis, said. “But central banks take a risk on credibility. If something unexpected happens, you have to deviate from what you have been announcing.”

The Fed’s reputation took a knock a year ago when global borrowing costs shot up after then chairman Ben Bernanke talked about the prospect of the central bank reducing its stimulative asset purchases “in coming meetings”.

Several Fed officials felt compelled to reverse the guidance in an episode that prompted criticism from around the world over the sloppy communications by the Americans.

The BoE also struggled with communication. In February it was forced to reconsider policy two-and-a-half years ahead of schedule. With caveats about the economy, it had promised to keep rates low at least until the unemployment rate fell below 7 percent, predicting that would take three years. It took six months.

In March, a month after the BoE’s reconsideration, the Fed dropped a similar pledge.

“There are a lot of people in central banks who fantasise about forward guidance because it means they can stop quantitative easing and still claim they are doing something,” said Adam Posen, a former member of the BoE’s policy setting committee who is now president of the Peterson Institute for International Economics.

“It was very attractive because… it does not cost us anything,” he said. “And like most things that don’t cost anything, it’s not worth much.” – Reuters


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