The Fog that cloaks “Forward Guidance”

David Beckworth has provided the best short statement on the futility of “guidance” (my bolds):

This spate of bad news for forward guidance should not be surprising. For it is like trying to navigate a ship by focusing on the expected path of its rudder. No ship captain can credibly commit to a certain rudder path across the ocean because water currents and wind conditions are bound to change. A captain, however, can credibly commit to a destination and do whatever it takes to get there. In this case, the rudder is not the focus and is adjusted as needed to offset the unexpected changes in current and wind conditions so that the ship stays on course.

Similarly, a central bank cannot credibly commit to a certain path for its policy rate if it wants to hit its destination. For most central banks that means full employment and stable inflation. Forward guidance commits the central bank to a path of low policy rates beyond this destination in order to get more stimulus today. That is akin to a captain saying it will keep his rudder and ship on a certain path even after they make it across the ocean. No one would take that claim seriously. The ship has to stop when it hits the shore. Likewise, a central bank cannot commit to a flexible inflation target and at the same time credibly commit to a path of policy rates that would violate this monetary regime. This is why markets are now challenging the FOMC’s forward guidance on interest rates. They see an economic recovery that will force the Fed to raise interest rates faster than the FOMC [or the BoE for that matter] says it will.

Interestingly, in his famous December 11 2012 speech “Guidance”, Mark Carney says:

In my remarks, I will discuss where such guidance can be effective and when it may be warranted. My main message is while transparency is critical to well-functioning capital markets and effective monetary policy, forward guidance of policy is best used sparingly in normal times. In extraordinary times, however, conditional guidance can be used to resolve time inconsistencies and achieve a better path for the economy.

Recent events have shown that this is not true. Beckworth´s summary is much more consistent. In effect, in that speech Carney left a “door open” in the (likely for him then?) event “guidance with thresholds” didn´t work:

From our perspective, thresholds exhaust the guidance options available to a central bank operating under flexible inflation targeting.

If yet further stimulus were required, the policy framework itself would likely have to be changed. For example, adopting a nominal GDP (NGDP)-level target could in many respects be more powerful than employing thresholds under flexible inflation targeting. This is because doing so would add “history dependence” to monetary policy. Under NGDP targeting, bygones are not bygones and the central bank is compelled to make up for past misses on the path of nominal GDP.

But it seems that´s not what´s happening. In Davos he told reporters that:

“The Bank’s assessment of how to evolve(!) guidance to changing circumstances will begin in our February Inflation Report.”

“The MPC will consider a range of options to update our guidance, recognising both what we have learned about the behaviour of aggregate supply in the economy as well as the more benign inflation outlook.”

Yes, I know Carney does not decide by himself. He has to convince a committee of ‘savants’ (as does Bernanke, and shortly Yellen). So it appears that strong leadership (and salesmanship) qualities should be an additional requirement for central bank chiefs.

5 thoughts on “The Fog that cloaks “Forward Guidance”

  1. I can’t understand why everyone thinks the unemployment/guidance approach has been a failure and not a smashing success. In my line of work achieving a goal much faster than you said you would is considered a good thing.

  2. Pingback: The Fog that Cloaks Forward Guidance « Economics Info

  3. Marcus
    I think “wrong goal” is too harsh, maybe there could have been a better way to frame the guidance, as in NGDPLT, but no-one could argue that reducing unemployment is a bad thing in itself.

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