Following the Fed’s surprise decision not to ‘taper’ its asset purchases this month, market participants feel misled. That’s hardly a surprise to UBS’ Amit Kara who has long argued that central banks have limited ability to guide markets, given that their policies must adjust to hard-to-predict outcomes. Policy pre-commitment is an oxymoron, and central bankers who pledge ‘forward guidance’ do so at considerable risk to their credibility. In an inherently uncertain world, central bankers must adjust current policies to achieve those outcomes. That makes it impossible to pre-commit to a given policy, given that flexibility is required to respond to unforeseeable circumstances.
Investors might be forgiven if they feel a bit like Charlie Brown just after Lucy (the Fed) pulled back the football (taper) just as they were determined to kick it, flipping them on their collective backsides.
On the shortcomings of ‘forward guidance’ as a communication tool of central banks
Perhaps best to state at the outset that I do believe that forward guidance can have some beneficial impact, but I have also held the view that the risk to the central bank’s credibility far outweighs the benefits and for that reason central banks should only deploy the guidance tool with great caution.
Forward guidance has a well known shortcoming known in the literature as ”time inconsistency”. Let’s start from the very reasonable position that the central bank will always do what it believes is right for the economy. We further assume that no one has a crystal ball and that there is every chance that the economy behaves differently from expectations. If the forecasts are wrong and the central bank will only ever do what is right for the economy, then the pre-commitment will simply not act as a binding constraint. Investors know this and it is hardly surprising that they are challenging central bank guidance.
Of course, those sympathetic to forward guidance will argue that the guidance framework designed by the Fed and the Bank of England (BoE) allows for this uncertainty by conditioning itself on a macroeconomic threshold — the unemployment rate — with clear and well-defined knock-out clauses. Sure, but there is also the fine print in both frameworks that essentially provides the central bank the necessary flexibility. That then is exactly the point – the caveats are so broad that they dilute the core message of pre-commitment.
The problem is particularly severe for the Bank of England. The UK economy has been difficult to forecast recently. The economy has suffered its deepest recession in decades, yet inflation remained stubbornly high over this period and the labour market surprised to the upside. This cocktail of macro outcomes is extremely unusual and was also very difficult to predict. We did not get our forecasts right, but more important for policy, neither did the BoE.
Central banks cannot have it both ways, i.e., offer guidance that implicitly signals that the ultra-accommodative monetary policy stance will hold for a prolonged period of time and also then claim that there is no precommitment. The end result is a likely loss in central bank credibility.
On unintended consequences:
…policy makers should be careful not to overstate the benefits [of their policy].
Exaggerating the unknown benefits of guidance runs the risk that the government and the public get complacent on what many might argue is the more urgent challenge, [for instance the need for microeconomic reforms that will unlock Japan’s growth potential]
On the fallacy of central bank transparency:
Central bank communication has undergone a major revolution over the past 20 years. Where in the past policy was almost opaque, the trend now is for complete transparency.
Transparency to the point where the public are given the impression, in our view, that the central bank has a crystal ball. In my view, the ideal mix is probably somewhere between the two – a simple and clear message that highlights the central bank’s reaction function but also highlights the risks.
So what does this mean for investors? Well, as they found out this month, central banks can spring surprises. It is therefore best to try to figure out what will prompt central bankers to change their minds. Understanding their ‘reaction function’ and adjusting probabilities for policy outcomes as the data arrive remains the least bad way to predict central bank policy.
We’re all data watchers now