Forward Guidance Hasn't Made Markets Less Volatile
At a conference in Frankfurt organized on Nov. 14, the heads of the U.S. Federal Reserve, the Bank of England, the European Central Bank and the Bank of Japan expressed views on the conduct of monetary policy, but did not provide markets with clues on future policy. Instead, the discussion dealt with the way messages would be transmitted to the markets.
Markets and investors will be better served if monetary officials spend less time providing guidance on their next steps, and more time devising and following pre-announced rules for the implementation of policy. By staying for a decade with what then-Fed Chairman Ben Bernanke referred to in 2008 as short-term “emergency measures,” the central banks have themselves become a big part of the uncertainty that investors have to take into account.
How did the central banks put themselves in this situation? After initially responding to the global financial crisis with the traditional tool of lower interest rates, all four major central banks undertook “quantitative easing,” the process of adding liquidity to markets through bond purchases. When even that was not sufficient to restore economic growth to its pre-crisis pace, “forward guidance” became the mantra. Through news conferences and minutes of meetings, central banks would indicate to investors the path they would follow. Officials hoped the guidance would make the markets less volatile.
Forward guidance has not achieved its objective of keeping investors informed about central banks’ intentions. Perhaps the most famous instance of a message gone wrong was the statement by Bernanke in his congressional testimony on May 22, 2013, when he said the Fed could decide “in the next few meetings” to start tapering bond purchases. While he meant to reassure investors that the central bank would not abruptly tighten policy, his statement had the opposite effect on markets.
The yield on 10-year U.S. Treasury securities surged from 1.93 percent the day before Bernanke’s testimony to a high of 2.74 percent on July 5 that year (see chart below). Bond investors equated a proposed reduction in monthly bond purchases to the start of a steady process of monetary tightening -- not the message the chairman intended to convey.
And in September 2015, after repeated signals that the Fed meeting that month would mark the first increase in interest rates since the financial crisis, the central bank backed off at the last minute. That spooked markets, which interpreted the move as evidence the Fed knew something negative about the economy that investors were not aware of. The Standard & Poor’s 500 index fell from 1,995 on Sept. 16, the day before the Fed decision, to 1,882 on Sept. 28 -- a decline of 5.7 percent over 11 days (chart below).
And in the most recent instance of forward guidance not working, officials had repeatedly signaled that BOE Governor Mark Carney would announce the first rate hike in a decade at the bank's meeting on Nov. 2. Even though Carney did so, the announcement resulted in a weaker currency and higher bond prices instead of bolstering the pound sterling and raising gilt yields. Investors had taken the BOE as having made a “once and done” decision, and bet that authorities would not hike rates again due to Brexit-related uncertainty.
Given the shortcomings of forward guidance, is there a better alternative for investors? One possibility comes from a proposal by John Taylor, a professor at Stanford University, who provided a formula in 1993 for setting interest rates. According to the Taylor Rule, the federal funds rate would be determined by the inflation-corrected interest rate, the extent to which actual inflation differed from the target and by how much the real growth rate varied from the economy’s potential.
A clear central bank decision rule -- whether based on Taylor or a credible substitute -- would allow investors to plug numbers into the equation to decide whether the central bank would tighten, ease or leave the policy unchanged. No guesswork involved. Instances of markets coming to different conclusions from monetary authorities, as in the three cases cited above, would be reduced, if not eliminated.
Just as important, clear rules would help minimize the risk to investors of erroneous policy due to human error. A prime example of the wrong step at the wrong time was the decision by the then-ECB President Jean-Claude Trichet to raise rates on July 2, 2008 -- just two months before the financial crisis caused global markets to plunge. The ECB had to cut rates in a hurry during subsequent weeks and months.
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