Clarity Versus Flexibility at the Bank of England
A month after taking charge at the Bank of England, Mark Carney has announced a decisive break with the old way of communicating the central bank’s intentions. The new way is “forward guidance,” pioneered by Carney at the Bank of Canada and subsequently adopted, with mixed success, by the Federal Reserve and the European Central Bank.
The idea is fine in principle, but, as the Fed and ECB have lately demonstrated, it’s tricky to apply in practice. The instant reaction to Carney’s announcement suggests as much. He said the central bank’s target interest rate would stay very low at least until the U.K.’s rate of unemployment falls to 7 percent, which he said might be in 2016. At this, the pound strengthened and long-term interest rates briefly went up -- in effect, a slight tightening of policy, one that Carney presumably didn’t intend.
The logic behind forward guidance is appealing. It starts with a question: How can a central bank ease monetary conditions if short-term interest rates are already at zero? The answer: Promise that rates will stay low, or that unconventional measures such as quantitative easing will stay in place, for longer than financial markets were expecting.
It isn’t as easy as it sounds. Everything depends on the clarity and credibility of the bank’s promise. With typical thoroughness, the Bank of England today published a detailed paper on the different forms forward guidance might take.
At one extreme is an unconditional promise to keep interest rates very low for a fixed period. This would be perfectly clear, though its credibility would surely be in doubt. (If inflation surged unexpectedly, would the bank keep its promise?) At the other is a promise so hedged with conditions and “knockouts” (as Carney calls them) that it conveys no real information. This looser commitment might be credible, but only because it doesn’t say anything.
Breaking promises is a bad habit for a central bank. Wisely, Carney’s formula tends to the latter end of the range. If the bank decides that monetary policy poses a threat to financial stability, interest rates could rise. If it decides that inflation two years ahead is likely to exceed 2.5 percent, interest rates could rise. Regardless of its own inflation forecast, if it sees that market expectations of inflation are no longer “well-anchored,” interest rates could rise. In addition, now that unemployment is an explicit metric for monetary policy, expect a new focus on how slack in the labor market is measured: Soon, perhaps, there’ll be new room for maneuver there, too.
If all else fails, the guidance can simply be changed. The Fed seems to clarify -- i.e., adjust -- its guidance month by month. How much new information, if any, markets detect in forward guidance this elastic is hard to say.
The fact that the pound strengthened after Carney’s announcement doesn’t show that the policy has backfired. Rather, it proves that controlling expectations is hard. Carney’s new policy had been anticipated, so some loosening of monetary conditions was already in place before he spoke. Central banks make their announcements -- but financial markets decide for themselves what to think.
Carney’s predecessor, Mervyn King, was a skeptic on forward guidance. There’s too much uncertainty about the future, he believed: Monetary policy, he said, using a cricketing metaphor, was a matter of “one ball at a time.” Carney’s approach to forward guidance looks flexible enough that it won’t snap under pressure, and that’s good. Whether it’s firm enough to make much difference, we remain to be convinced.
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