The world’s most powerful central banks are struggling with their approach to “forward guidance” -- what they tell investors about their plans for monetary policy. A practice meant to give the markets more clarity is causing confusion.
The basic thinking behind forward guidance is simple: If investors understand what central banks intend, they’ll be less surprised as conditions change, and markets will adjust more smoothly. In addition, a credible promise to keep inflation low helps workers, companies and investors align their expectations. This kind of forward guidance was firmly established as central-bank orthodoxy before the crash.
With interest rates stuck at zero, central banks have been unable to provide further monetary stimulus in the usual way. So they’ve asked forward guidance to do more. A promise to keep interest rates low for longer, if believed, will stimulate demand. But note an important difference: In this new role, forward guidance aims to change expectations rather than confirm them. To make this new kind of guidance more credible, the U.S. Federal Reserve and the Bank of England, especially, have made it more detailed, and hence more complicated.
For example, they’ve promised to keep interest rates very low at least until certain unemployment thresholds were reached. In both countries, unemployment has fallen faster than expected -- meaning the thresholds are closer than anticipated, and the banks’ plans for raising rates are more uncertain than intended.
At any rate, as Atlanta Fed President Dennis Lockhart points out, the unemployment rate has turned out to be a poor guide to the state of the jobs market and wider economy. Joblessness is down in the U.S. not because jobs are being created, but because workers have dropped out of the labor force. So the Fed’s guidance will have to be tweaked.
Bank of England Governor Mark Carney, an evangelist of the new approach, faces a different problem. The U.K.’s unexpectedly strong recovery has indeed created plenty of jobs in recent months. If Carney meant what he’s said about forward guidance, there should now be a reappraisal of the central bank’s plans for interest rates. Yet U.K. inflation fell to its target rate of 2 percent in December. With inflation falling, there’s no need yet to raise rates. Policy would have been easier to explain, and investors’ expectations easier to steer, if not for forward guidance.
The European Central Bank has also been confusing investors, as various ECB board members try to explain what Mario Draghi, the bank’s president, meant last year when he said interest rates would stay low “for an extended period of time.”
In all this, there’s an underlying dilemma for the central banks: If forward guidance is to provide additional stimulus, the central banks have to change investors’ understanding of how interest rates will respond to economic conditions. Yet, for the sake of credibility, the Fed and the others want investors to see monetary policy as steady and consistent. Much of the effort to get forward guidance right is a doomed effort to have it both ways.
For instance, demand would grow if a central bank made a credible promise to raise inflation. But a central bank’s very credibility rests largely on its commitment to keep inflation low. Put it this way: A promise to be reckless would increase demand -- but no sane central banker would promise to be reckless.
The central banks might choose to make their guidance even more detailed -- adding more labor-market indicators or other measures of economic slack, for instance. It would be better to move back to greater simplicity.
The central banks should continue to make public their assessments of economic conditions, and affirm their goals of keeping inflation on target (which, in Europe at least, would justify new monetary stimulus) while supporting economic activity. Beyond that, they should retain operational discretion as circumstances change, and let actions speak louder than words. Asset purchases, or quantitative easing, undertaken at sufficient scale, can continue to provide stimulus even with interest rates at zero. To be sure, there’s a limit to what QE can do without causing financial instability -- the balance of costs and benefits tilts over time -- but no big central bank has reached it yet.
A more radical alternative is also worth considering: replacing inflation targets with targets for growth in total demand, also known as nominal gross domestic product. This would allow for temporary overshoots in inflation in response to periods of very low demand, thus providing extra short-term stimulus, without unsettling long-term inflation expectations. And unlike ad hoc targets and thresholds, it’s a framework that stays in place throughout the economic cycle.
A move (perhaps in stages) to NGDP targeting or a return to more straightforward inflation targeting -- in both cases, with QE to provide stimulus when interest rates are stuck at their zero floor -- is more feasible than, say, adopting a higher inflation target. In any case, candid discussion of the banks’ economic assessments can and should continue to provide further guidance of a sort, and that’s valuable.
The central banks’ task is hard enough. Additional numeric targets, thresholds and criteria would make it even harder.
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