General reflections on forward guidance

In the past six weeks both the ECB and the Bank of England have introduced forms of “forward guidance” for their monetary policy. Both forms of language are similar to that deployed by the US Federal Reserve in the past.

The ECB’s claim that it expects “rates to remain at present of lower levels for an extended period of time” is similar to language used by the Fed in 2009. The Bank of England’s (BoE’s) claim that the current level of policy accommodation would be maintained until at least an unemployment threshold had been met, contingent on inflation “knockouts” not being hit, is almost identical to the Fed’s current forward guidance framework.

For both central banks, this was an innovation in language. Hitherto any forward guidance about the timing of any rate increases has not been explicit, and was only, to an extent, implicit in their forecasts for growth and inflation. And in their recent statements, both central banks have been keen to point out that they did not regard markets’ expectations of rate increases in coming years as being justified.

That said, the response of some market participants and commentators has been fairly sceptical. For some, the ECB’s use of the word “extended” is too vague and unspecific to be meaningful and the Bank of England’s “knockout” clauses render their forward guidance fairly impotent as well. It seems that unless these central banks irrevocably commit to keep rates low until a specific date, many see forward guidance as a futile gesture. Certainly markets’ reactions have been underwhelming.

One reason for that may be that both central banks have emphasized that forward guidance is a clarification, not a change, of their reaction function or policy strategy. At the margin, that reduces some of the uncertainty for markets. And, importantly, it allows the message, that rates are likely to remain low for some time, to be more effectively transmitted to economic agents in the corporate and household sectors.

But in recent weeks, “clarifications” of these central banks’ reaction functions and policy strategies may have proved less substantive news for markets than growing evidence of an upswing in economic activity across Europe.

What both central banks have done is make their policies state dependent, although the BoE has been far more specific. Part of the purpose of the forward guidance may be to provide greater confidence to market participants that the policy response will be more to do with the level, rather than growth, of activity. In effect, the strong correlations of policy changes with growth rates in the past no longer hold, and growth doesn’t just need to be stronger to prompt policy change, it needs to be stronger for a considerable period of time.

The dovish tone to both central banks’ guidance, with for example the MPC suggesting that it was more likely than not that rates would be on hold for three years, is in large part a consequence of fairly dovish forecasts of those “states” on the part of both central banks. The issue for markets is that those “dovish” forecasts could be wrong, and if they are, the “extended period” of the ECB, or three years of loose policy from the BoE, could prove shorter. That’s particularly relevant given the recent improvement in a broad range of cyclical indicators, and consequently, it’s worth considering the circumstances and timing in which forward guidance of both central banks could elapse.

James Bevan is chief investment officer of CCLA, specialist fund manager for charities and the public sector. CCLA launched The Public Sector Deposit Fund in 2011 to meet the needs of local authorities and other public sector organisations. You can follow James on twitter @jamesbevan_ccla