Forward Guidance Risks Stoking Instability, BIS Says

Central banks employing forward guidance risk creating financial instability by revising the policy or keeping borrowing costs low for too long, according to economists at the Bank for International Settlements.

As they seek to foster economic growth, the Federal Reserve, the European Central Bank, the Bank of England and the Bank of Japan have pledged to hold down interest rates to spur lending to households and businesses. Evidence on the effectiveness of the policies is mixed, meaning no firm conclusions can be drawn about their ultimate value, Andrew Filardo and Boris Hofmann argued in a paper published yesterday in the BIS Quarterly Review.

“If financial markets become narrowly focused on certain aspects of a central bank’s forward guidance, a broader interpretation or recalibration of the guidance could lead to disruptive market reactions,” Filardo, head of monetary policy at the Basel, Switzerland-based BIS, and Hofmann, senior economist, wrote. It may also “translate into an undue delay in the speed of monetary policy normalization and raise the risk of an unhealthy accumulation of financial imbalances.”

Fed Chair Janet Yellen and BOE Governor Mark Carney have said they won’t start discussions on increasing interest rates until unemployment falls below a certain threshold. ECB President Mario Draghi has pledged to keep borrowing costs at “present or lower levels for an extended period of time,” while the BOJ links its key rate to inflation.

Lower Volatility

“We should be aware of risks, of the unintended consequences of our policies,” Charles Plosser, president of the Federal Reserve Bank of Philadelphia, said in a Bloomberg Television interview today. “Monetary policy has taken a lot of risk around the world, not just in the U.S. We’ve initiated programs and policies that we’ve never tried before.”

Carney is due to appear before lawmakers on Parliament’s cross-party Treasury Committee in London tomorrow to answer questions on the modifications he made to forward guidance last month. The BOE was forced to refine the policy to focus on the amount of spare capacity in the economy, after jobless fell toward the 7 percent threshold for considering a rate increase.

While forward-guidance policies have helped subdue one-year interest-rate volatility, they are less effective at influencing longer maturities, the BIS report said.

There is “some support” to the view that guidance “helped to shape market expectations,” Filardo and Hofmann wrote. “Recent forward guidance by four major central banks has so far reduced the volatility of near-term expectations about the future path of policy interest rates. Beyond the impact on near-term policy rate volatility, the evidence is more mixed.”

The measures also pose reputational risks “if guidance is revised frequently and substantially,” the report said.