Psychology and forward guidance
Carney’s move could be counterproductive
by Gabriel Stein and David Marsh
Fri 9 Aug 2013
A degree in economics, perhaps in political science or law, used to provide perfectly adequate preparation for the post of a central bank governor. These days, as the latest news from the Bank of England about ‘forward guidance’ illustrates, perhaps a doctorate in psychology is required. We have Ben Bernanke dancing metaphorically on a pin-head about the exact definition of tapering (a word that used to be applied more to altar candles than interest rates).
Mario Draghi has the financial markets in the palm of his hand after launching a programme called Outright Monetary Transactions, the utility of which lies in the great unlikeliness that it will ever be used. And now we have Mark Carney filling acres of newsprint and zillions of megabytes with conjecture about how long UK interest rates are likely to remain at their present low record levels.
At least the present leaning towards saying that interest rates will stay low unless something happens to make central banks put them up again is a change from previous fashions. There are few who lament the passing of the rigorous rhetoric of Jean-Claude Trichet, the previous European Central Bank president, whose mantra ‘We do not precommit’ became as well-worn a part of his statements as his constantly-repeated (between 2004-08) assertions that convergence of long-term interest rates between Germany and Greece was good for Europe.
The Bank of England’s Carney on Wednesday made clear that the Old Lady is now following in the footsteps of other central banks, most recently the Federal Reserve and the ECB, in giving greater information about likely interest rate patterns in coming years. The setting of a UK unemployment trigger – 7% compared with the present 7.8% – for an interest rate rise is important and reasonably dramatic, but so is the list of factors that could override the link: expectations for higher inflation by the Bank of England and/or the population at large, and perceived threats to financial stability.
In theory, forward guidance is supposed to calm financial markets – and the public at large – by outlining the likely future course of monetary policy. However, there is a problem. Any commitment to future policy is and must by necessity be contingent, to a certain extent, on future developments. But markets don’t want contingency-dependent commitments; they want firm promises.
When statements about the future are so hedged with conditions that there’s a high probability that they will be inoperable, markets are unlikely to be deluded into treating forward guidance as a promise. This is risky and could be counterproductive. We shall see whether the costs of forward guidance may even outweigh the benefits.
This topic will be developed further in an article in the September OMFIF Bulletin.
Prof. Gabriel Stein is OMFIF Chief Economic Advisor, David Marsh is Chairman.
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