Global Overview - Guiding on Guidance
Managing the public’s expectations about the evolution of certain economic variables has long been understood as a key aspect of monetary policy. This is because forward-looking agents base their decisions today in part on their expectations of the future. This is true of both the central bank’s targets and the instruments it uses to reach these objectives. So when it sets the short term interest rate, what really matters to the transmission of this policy is what people think about the entire future path of the short rate. Central banks can guide these expectations indirectly by committing to certain targets, explaining how they view the trade-offs around these targets, and suggesting how they would behave in certain situations; or they can do so directly by providing their own forecasts about the path of policy.
Since the financial crisis, a number of major central banks have moved further along this spectrum to provide more explicit guidance. In large part this move was in response to interest rates falling to the lower bound, and central banks needing to find new tools to ease financial conditions. The idea was that guidance could help reassure people that monetary stimulus would not be removed as soon as the economy started to recover, which should help boost activity. This type of guidance is most powerful when the central bank credibly commits to not tighten policy unless certain conditions are met – either a period of time has lapsed or the economy has performed in a particular way. This is sometimes known as Odyssean guidance after the Greek hero Odysseus, who tied himself to his mast to remove his scope for future (in)discretion.
As the lower bound has ceased to be a binding constraint for a number of economies, and central banks have turned to tightening policy, the role of guidance has shifted. Guidance now typically takes the form of forecasts about policy, both around the timing of the next rate hike and the entire path of policy. This has helped to clarify reaction functions, reduce uncertainty, and anchor expectations for a gradual hiking cycle. However, central bank forecasts can be wrong, so it is important to avoid putting too much weight on current guidance (see chart 1).
US - US monetary policy: guiding light
The Fed’s forward guidance has come a long way. In the early ‘90s, the central bank would not announce that it had changed interest rates after a meeting. Rather, market participants were left to decipher what the FOMC had done through open market operations. This post-meeting silence was broken in 1994 with the publication of the first FOMC press statement, which simply informed markets that they should expect “a small increase” in interest rates. Guidance evolved slowly over subsequent years. For example, the committee started to signal if risks were symmetric to the outlook, before talking more explicitly about inflationary pressures or economic weakness. Things stepped up in early 2000s with the Fed providing stronger signals that accommodation would be “maintained for a considerable period”. Forward guidance became more elaborate as the financial crisis struck. First the Fed promised to keep rates low, and signalled a willingness to increase asset purchases. Next, guidance became calendar-based, with rates anchored until at least mid-2013 (and subsequently later). This evolved into state contingent guidance, with the Fed announcing that rates would remain at the lower bound as long as the unemployment rate was above 6.5% and inflation anchored (see Chart 2). Certainly the FOMC has become much more talkative over the past two decades.
This isn’t empty talk. The central bank uses increasingly detailed guidance about the future path of monetary policy to help individuals and businesses make spending and investment decisions. This becomes more important as rates hit the lower bound, and policymakers are forced to turn to other tools to boost inflation and growth. However, this process hasn’t been seamless. Calendar-based guidance came in for criticism for creating confusion – for example, was the reference to mid-2013 a forecast that the economy would remain until that point, or a signal that policy would remain loose regardless? These wrinkles were ironed out, and most empirical studies suggest the increasingly powerful signals provided by the Fed have had clear effects on the economy. Indeed, the Kansas City Fed found that changes in guidance were credible and lowered market pricing for short-term rates, providing additional stimulus to the economy. However, the study did highlight that these effects were limited by an already low short-term interest rate structure. One option would be to offer guidance on longer time horizons, although the FOMC might be uncomfortable in investing its credibility in guidance over these uncertain horizons.
The Fed’s communication is changing again as policy is tightened. Part of this has seen communication focus on interest rates as the primary policy tool, with the ongoing adjustment in the Fed’s balance sheet on a pre-set glide path. However, even on rates, guidance is being used less (see Chart 3). Chair Powell has stated that while this was useful during the crisis, it will have “a much smaller role going forward”. Subsequently, we have seen the Fed cut the message that rates are “likely to remain, for some time, below levels that are expected to prevail in the longer run” from its statement. This leaves policy on a more data-dependent path, with the Fed looking to carefully calibrate its tightening cycle amid understandable uncertainty around where the terminal rate sits. However, when the next downturn strikes, expect guidance to be one of the first tools the Fed reaches for.
UK - Forward guidance in the UK: it’s conditional
In his first act as Bank of England (BoE) governor in August 2013, Mark Carney formally introduced forward guidance to the Bank’s toolkit. The BoE committed to not increasing interest rates at least until unemployment fell below 7% (at the time it was 7.7%). There are two important features of this form of guidance: first, it links policy to the state of the economy; second, it commits the Bank to a particular path of policy. This is sometimes known as state-contingent Odyssean guidance, because it ties the hands of the central bank. The idea is that this can help to provide extra stimulus when interest rates can’t be pushed any lower, by reassuring people that even when the economy recovers monetary policy will not be tightened rapidly. As the economy recovered, and the Bank started to consider tightening monetary policy, the form of guidance it used changed significantly. From February 2014, the Bank started saying that it expected the equilibrium level of interest rates to remain lower than the past and, as such, it expected its hiking cycle to be “limited and gradual” (see Chart 4). This is sometimes known as Delphic forward guidance, as it only amounts to a forecast rather than any sort of commitment or promise.
This “limited and gradual” guidance still underpins the Bank’s policy stance, and is meant to help clarify the Bank’s reaction function and reduce uncertainty in the path of rates. Along with this guidance about the broad path of rates, the Bank also tends to provide Delphic guidance about the timing of its next policy move. For example, in July 2015, Carney hinted at a rate hike “around the turn of [the] year”, and the minutes of its September 2017 meeting noted that “some withdrawal of monetary stimulus is likely to be appropriate over the coming months” (see Chart 5). It is this form of guidance that seems to get most attention, especially as the Bank has typically not followed through on this guidance. This “inaccuracy” has seen Carney called an “unreliable boyfriend” by some, and, more seriously, may hurt the Bank’s credibility, especially as the point of Delphic guidance is to reduce uncertainty. However, there is nothing necessarily wrong with policymakers changing their minds as the economy evolves. True credibility ultimately comes from doing the right thing to meet objectives, not following through on guidance that may no longer be appropriate. Thus, it is often far more important to watch the evolution of data rather than the utterances of individual policymakers in predicting monetary policy. And on the basis of the recovery of UK data in the second quarter, we continue to expect the Bank to hike rates again in August.
The Bank of England provided another form of guidance at its last policy meeting, signalling that it planned to start the process of running down the size of its balance sheet when Bank rate reaches 1.5%. Not only does this provide explicit guidance about balance sheet policy, it also provides some guidance about how low the Bank thinks interest rates can fall. When the Bank thought 0.5% represented the lower bound for rates, it suggested balance sheet unwind would start when rates reached 2%. This new guidance seems to imply the Bank now thinks 0% represents the lower bound, which may turn out to be significant in future downturns.
Europe - The European Central Bank: two steps forward, one step back
The ECB’s experience with forward guidance began in July 2013, when the introductory statement included the line that “the Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time”. Since then, forward guidance has been adapted on a number of occasions. From 2015 onwards, the ECB has used forward guidance to give an intended horizon for net asset purchases – continually pushed out, until the final tapering announcement that will see purchases cease at the end of this year. In December 2016, it added a line that “if … the outlook becomes less favourable … the Governing Council intends to increase the [asset purchase] programme in terms of size and/or duration”. And the guidance indicating the likely date of rate rises has been altered at various points, first to “well past the horizon of net asset purchases”, and, most recently in June 2018, to “at least through the summer of 2019 and in any case for as long as necessary”.
In the typical typology, ECB forward guidance has been Delphic (like the mutterings of the Delphic oracle, it has communicated ECB expectations about the most likely path of policy in the future, rather than ironclad commitments), conditional (linking likely policy action to qualitatively described states of the economy), and at various points either open-ended (“for an extended period of time”) or calendar-based (“at least through the summer of 2019”). The ECB has described its forward guidance as “clarifying the Governing Council’s assessment of the inflation outlook … and its monetary policy strategy based on that assessment”. In other words, the purpose of ECB forward guidance has been to help economic agents more accurately infer the likely future path of interest rate and balance sheet policy, especially in times of heightened uncertainty. For most of the post-crisis period, the concern has been that investors, businesses and consumers would anticipate tighter monetary policy inappropriately soon – so forward guidance has been a tool to increase overall monetary policy accommodation by anchoring expectations for policy more firmly around a path warranted by the ECB’s assessment of the outlook.
Has it worked? By and large, yes. Event studies suggest that successive pieces of forward guidance from the ECB led to a reduction in interest rates across the entire maturity spectrum, as interest rate expectations moved into line with the ECB’s own forecast of the appropriate path. President Draghi, for example, said of the downward shift in market rate expectations after the enhanced forward guidance of 14 June 2018 (see Chart 6) that “the path of very short-term interest rates that is implicit in the term structure of today’s money market interest rates broadly reflects [ECB] principles”. ECB forward guidance has also reduced uncertainty about future policy and lowered the sensitivity of market rate expectations to every little bit of economic data. But the fact that the ECB is still engaged in forward guidance, five years after it first told markets it expected to keep rates very low “for an extended period of time”, suggests that, even combined with ultra-low rates and asset purchases, forward guidance didn’t make policy accommodative enough to bring inflation back to target over a typical monetary policy horizon (see Chart 7).
Japan and Developed Asia - Bank of Japan’s Kuroda: the boy who cried wolf
Governor Kuroda has downplayed an official review of the current inflation soft patch, arguing another comprehensive assessment is unnecessary. We would agree with the conclusion even though our logic may differ considerably. The comprehensive assessment may have been designed to boost transparency around policy under Kuroda. However, monetary policy communication should not be simply an issue of information sharing. Central bank transparency should be considered as a means to 1) boost policy effectiveness 2) demonstrate accountability 3) build widespread support for central bank independence. We think the BoJ is failing on all three accounts.
In the context of monetary policy efficacy, communication is an important mechanism to help shape private sector expectations. In Japan’s case, the gap between the Bank and consensus expectations on core CPI is remarkably large and persistent (see Chart 8). Furthermore, the Bank’s own forecasts lack confidence, with eight of the nine board members confessing to downside risks to their FY2020 price forecast. Unsurprisingly, the private sector pays little attention to Kuroda’s repeated statements that the BoJ is on track to meet its inflation target. Since downside revisions to the price outlook has become the norm, the market’s assessment of the Bank’s reaction function has been skewed. It is incumbent on the Bank of Japan to both explain how it will reach its forecasts and to reassert the state contingency of its policy settings. To this end, we expect the Bank take an axe to its price forecasts in its Outlook Report in July, significantly closing the gap with the private sector. It will be essential that this is accompanied by a more balanced outlook on the longer term risks, as well as a renewal of the Bank’s commitment to adjust policy as necessary.
The other critical concern for the BoJ as it ponders its communication strategy in the coming months is how it should address the government’s fiscal plans, with a final decision on the proposed VAT hike expected in November. While not officially part of its remit, keeping an eye on fiscal policy may, as Mervyn King famously quipped, be a bigger obsession for central bankers than inflation itself. Kuroda has taken a discreet approach of late, having been burnt when Abe decided to delay the VAT hike in June 2016 despite the urging of its monetary policy chief. Comments that have surfaced on the government’s tax plans have downplayed the impact on the economy compared to the 2014 hike. While this approach is clearly designed not to scare off the government, the problem may become more critical if growth does not rebound strongly in Q2 and Q3 (see Chart 9). A delay would further shift the balance of the government’s fiscal sustainability strategy, deepen financial repression and raise greater questions about the central bank’s independence. Against such a backdrop it would be increasingly right for questions to emerge over the commitment of the Bank to its price stability mandate and the veracity of the Bank’s internal management. We remain hopeful that Kuroda’s second term will see the Governor seek to clarify and simplify monetary policy following a turbulent few years. A better communication policy is imperative to achieve this.
Emerging Markets - Chinese policymakers: choosing growth over reform
The long-awaited decision between growth and deleveraging is now upon Chinese policymakers. The economy has seen multiple quarters of above-trend growth despite continuously weaker credit growth (see Chart 10). This was due to the combination of higher producer prices, rapid profit growth, and very strong external demand keeping investment and overall growth at target levels. This allowed policymakers to enact successful new regulations that constrained shadow banking and overall leverage without having to choose between reform and growth. With domestic demand weakening and the perils of a trade war looming, officials will once again have to choose between loosening the credit taps or continuing efforts to deleverage the economy. Lately officials have signalled they will try to have both: Wang Yiming, the State Council Development Research Centre vice director, said stimulus is called for given the tough global environment and domestic pressures, but he warned it “must not weaken the deleveraging agenda”. So far the government has looked at targeted monetary expansion as the solution, attempting to help small and micro businesses. However, problematically, directed lending aimed at easing credit for small, private sector businesses often fails to materialise as banks still prefer lending to state-owned enterprises.
Thus, policymakers are now facing a decision of broader easing and credit expansion to support growth or allowing growth to slow further while continuing on their deleveraging agenda. Recent language from the People’s Bank of China (PBOC) suggests there is more easing to come. In the Q2 PBOC monetary policy committee (MPC) report there were some key language changes from the most recent report in Q4. The PBOC has become more cautious on its global economic outlook with calls for better forward-looking policy fine-tuning and "reasonably adequate" liquidity conditions, and has softened its tone on deleveraging. These changes are in line with recent shifts of the PBOC's policy stance, such as the RRR cut, and supports the view of more policy easing measures in coming months.
From recent visits to China, an increasingly held view holds that the deleveraging agenda has gone too far, and efforts from both the PBOC and banking regulator have been too much, too quickly. Additionally, there was a worry that information on the extent of growth weakness was not reaching senior policymakers due to centralisation of power and fears of telling ‘truth to power’. The PBOC MPC report suggests this might be changing. Subtle language changes, including removing the statement to "effectively rein in macro leverage", which was used in its Q4 briefing, and replacing “deleveraging” with “structural deleveraging” might mean the government has become increasingly aware of the disruptive risks from deleveraging. Other than the MPC language, other recent actions suggest a shift towards easing: large liquidity injections through pledged supplementary lending (see Chart 11), and a 50 basis point targeted RRR cut coming into effect this week. Other actions will follow, as policymakers once again choose growth over deleveraging; and, in light of the looming domestic and international headwinds, there could be additional RRR cuts, increased commercial bank lending quotes, and further injections.