Wednesday, August 7, 2013

Does Forward Guidance Actually Work?

This piece is intent to give a background discussion for the use of forward guidance by central banks and recently adopted by the BoE (as of today, August 7th, 2013) 

Background:

Forward guidance, which are commitments by central banks to keep interest rates for a specified period or until a specific threshold has been reached, is new to a central banker's toolbox. It was actually first tested in New Zealand in 1991 with mixed results. The aim of this policy is to assure investors and consumers, who often overreact to changes in economic conditions, that monetary policy will stay accommodative for specified period of time or until the economy is in better shape as indicated by some sort of economic variable such as unemployment rate or real GDP growth. The more traditional monetary policy tool is to adjust the main central bank interest rate to provide accommodation. However, with main rates at near 0% in most developed countries (0-0.25% in U.S., 0.5% in U.K, 0.5% in E.U, and 0.25% in Canada in 2009), a new policy tool is needed as main policy rates cannot drop below 0%. 

Test 1: The BoC conditional commitment in 2009: 


A first test of modern forward guidance was implement by the Bank of Canada (BoC) in April 2009 that stated the main overnight rate will stay at 0.25% conditional on the outlook for inflation (CPI). This conditional commitment was extremely effective in lowering long term interest rates and helped the Canadian economy recovery faster than the U.S. during the 2009-2010 recovery. By mid-2010, Canada recover all the jobs it lost during the recession but the U.S. hardly gain 20% of the jobs it lost during the recession. With inflation expectation increasing in early 2010, the bank removed its pledge in April 2010 and hiked its rate by 75 bps to 1% by September 2010, where it still stands today. 

Test 2: Fed's forward using technical wording:


Seeing the success of the BoC, the Fed was eager to try forward guidance itself in 2010. With bond market pricing in a rate hike after the FOMC rise the discount rate (the rate banks borrow directly from the Fed's own discount window. This rate is different from the main federal funds rate) by 25 bps in February 2010, the FOMC wanted to dissuade the market from pricing a aggressive policy tightening bias. They added the ambiguous phase "rates will remain accommodative for an extended period of time". What is this "extended period of time" actually mean?  The effect hardly moved markets at all. Test 2 failed. 

Test 3: Fed's forward guidance using a particular date:


With the end of QE2 in June 2011, the FOMC avoided increasing the size its balance sheet  right away. Instead it tried to guide the path of the main policy rate by stating "rates will remain low until mid-2013". Thus putting a direct date on when they may hike rates. The markets reacted slightly but the U.S. economy kept on decelerating. A new method is needed. Test 3 failed. 

Test 4: Fed's forward guidance by introducing economic thresholds:

It is interesting to note how test 1 actually worked well but test 2 and 3 failed. The reason was because test 1 linked the path of the policy rate to a MOVING economic variable, mainly the inflation rate. The extended period language was far too vague to provide the transparency necessary to impact the market. Also, the date targeting method is too inflexible and does not take into account constant changes in economic variables. Thus, in December 2012, the FOMC formulate the newest form of forward guidance by stating "the main policy rate will remain low as long as unemployment rate remains above 6.5% and inflation expectations does not move 0.5% above the 2% target". The linking to moving economic variables allows market to adjust expectations accordingly and had a much more impact on interest rates. This policy did help U.S. gain over 20% so far in 2013 and help to push down junk bond yields below 5% (which is unheard of!). 

Conclusion: 

The key to successful forward guidance is the credibility of central bank. I have to agree that this new policy has provided some stimulus via lower bond yields and limit irrational moves in the fixed income market especially in the longer end of the curve. Nonetheless,  I think there is a risk that central banks are making incorrect forecast which may erode the usefulness of the guidance. Although the risk is small, I agree with famous investor Prem Watsa there may still be a deflationary threat with the Chinese economy slowing down and the tapering (of QE) discussion made little focus on the low inflation numbers reported (both CPI and PCE wise). As for the BoE guidance today to maintain rates low at 0.5% until unemployment reaches 7%, I think there is a real risk that they are likely to abandon this guidance if inflation are more sticker than BoE projects. Inflation in the U.K has been north of 3% for pretty much last two years and the path to towards the 2% target may be much more difficult than the BoE thinks. GBP investors saw this today when the pound actually rose 1.5 cents (that's the opposite reaction to what is suppose to be a more accommodation policy!) against the USD. All in all, forward guidance is a neat tool in a zero interest rate environment but I have doubts on the long-term effects. There is no doubt the short-term effects are pretty obvious with higher stock markets and tamed yields but the long term effect is hard to measure. 

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BoE announcement today can be found in the Governor Canrey's opening remarks http://www.bankofengland.co.uk/publications/Documents/inflationreport/2013/irspnote070813.pdf

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