Keeping your word is hard. People simply hate it when you don’t, something that central bankers enamored of the vogue for “forward guidance” may soon learn.
The Federal Reserve put forward guidance — essentially a pledge or promise to keep policy within certain parameters for a set period of time or given certain conditions being met — at the center of its strategy for keeping control over market interest rates while withdrawing from bond buying. In announcing a $10 billion per month taper, or reduction in bond buying, the Fed sweetened the medicine by hardening forward guidance to indicate that rates could remain near zero “well beyond” the time unemployment drops below 6.5% so long as inflation remains below a 2% target.
In some ways this has worked admirably; markets for risky investments remain upbeat. But in other areas, namely the exchanges where people make bets about future interest rate moves, things seem to be getting away from the Fed.
Back to that in a minute, but first let’s look at why central banks are now so taken with the idea of expectation setting as a monetary policy tool. In part it is because forward guidance is a tool that potentially turns the screws even when rates are near zero, and does so without actually buying anything.
In part though, this is simply the latest in a series of vogues for one technique or another. In the 1980s central banks tried to control the money supply, while more recently it was all about inflation targeting. Whether this was the march of science or the march of folly we will leave history to decide, but change has been a constant.
The issue with all of this is that it is a different person — sometimes literally, as with outgoing Fed chief Ben Bernanke now — making the promise for the one who will later be called upon to fulfill it.
Of course, central bankers will do as they see fit, within the parameters of the powers allotted to them, based on what they see at the time. Any other expectation is ludicrous, any other course of action counterproductive.
A central bank could of course, as the Bank of England is doing, construct an ever more complicated Rube Goldberg apparatus of “knockouts” — conditions under which it might vary from its pledged course of behavior.
The BOE has said it won’t raise rates above the current 0.50% until unemployment falls to a threshold of 7%, so long as none of the following “knockouts” occur:
- The BOE believes that inflation 18-24 months out will be 0.50% or more above the 2% target
- Medium-term inflation expectations are no longer well-anchored enough
- Monetary policy is seen as a significant threat to financial stability.
As if to emphasize how tenuous this all is, recent minutes from the BOE’s rate-setting meeting indicate that now that unemployment is falling much more quickly than it anticipated, it is beginning to doubt the data! That simply goes to underscore that life is so much more complicated than a central banker’s promise, or the rubric that underlies it.
None of this is surprising, or even controversial. Instead what is surprising is the idea that forward guidance will have some special power over markets.
Stanley Fischer, reported to be in line for the job of vice chair of the Fed, expressed some concerns over forward guidance earlier this year. “You can’t expect the Fed to spell out what it’s going to do,” Mr. Fischer said. “Why? Because it doesn’t know. We don’t know what we’ll be doing a year from now. It’s a mistake to try and get too precise.”
Other remarks from Fischer show him to be more comfortable with knockouts than hard date pledges, but the point broadly remains the same: It is tough to make and keep promises when the future is unknown.
That leads us to market reaction since the Fed announced its most recent forward guidance. In short, the market is getting way ahead of the Fed, at least as judged by its own predictions.
Fed rate-setting committee members broadly see rates at 0.75% by the end of 2015, with only two committee members seeing any rate hikes at all next year. In contrast, futures markets have been moving quickly to price in a faster pace of tightening. Financial markets believe the first rate hike will be in March of 2015 and short rates north of 1.00% by the end of that year.
As a gap opens up between the Fed’s promises and the market’s belief, the cost will be levied in the usual way with financial markets — by volatility.
—James Saft. Saft is a Reuters columnist.