"There's no alternative in making Monetary Policy but to communicate as clearly as possible and that's what we tried to do," stated Ben Bernanke in his most recent Press Conference on September 18. But is there?
Forward Guidance is a form of communication by a central bank that aims to signal the future path of interest rates and to shape the expectation of the public. In essence, the policy makers are trying to anchor the expected short-term interest rates, which translate into stable and low long-term interest rates through the term structure. Furthermore, we have evidence that aggregate demand relies not upon current short-term rates directly, but rather upon expected long-term real rates, which, as we proved, are determined by expected short-term rates. In theory, when guidance is provided, people are convinced the cost of borrowing and savings rates will remain low in the foreseeable future, which will make them inclined to spend more money today.
This policy is particularly useful nowadays, when the federal funds rate is at 25 basis points - the zero lower bound. In extreme situations like this, central banks use unconventional monetary policies, such as Forward Guidance.
However, you have probably noticed already the limitations on the effectiveness of this strategy. Namely, if central banks and the Fed, in particular, want the public to align their expectations accordingly, they need to establish strong credibility among investors, by keeping their promises, whatever they might be, for long periods of time. From the short history of transparency of the central bank in the United States, however, we can see it is hard for investors to base their rational expectations on what the Fed says.
Forward Guidance in Practice
Forward guidance and transparency were not always so popular. It was in the last two decades that central bankers decided to enhance communication with the public. Prior to this shift, policy makers did not believe guidance could be beneficial for the economy. For example, in the beginning of the Greenspan era (1987 - 2006) all information coming out of the Fed was vague and unclear. It took Greenspan two decades to fully appreciate the value of clarity. This dramatic shift can be observed in two of his most famous quotes:
"Since I've become a central banker, I've learned how to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said."
"[O]penness is an obligation of a central bank in a free and democratic society."
Undoubtedly, one of the most effective forward guidance tools is the FOMC meeting statement, which first appeared in early 1994. Since then, this statement has dramatically evolved to the point where it is clearer and includes everything about the Fed's strategy that investors need to know. Some of the key changes were:
- 1995 - Added analysis of the economic situation and the reason behind Fed's past actions
- 2000 - Added description of the economic risks lying ahead
- 2002 - Added FOMC members' individual votes
- 2003 - Added forward-looking guidance
The ensuing evolution of the statement was even more significant. It started with the Fed simply reporting on current economic conditions and the policy actions that they were going to take as a result, and not committing to any policy rule. The central bank could change the Monetary Policy strategy in response to events that differ than the forecasts, thus providing itself flexibility and room for adjustment.
When Bernanke was appointed chairman in early 2006, he further increased the transparency in the Fed's actions and committed to taking specific actions, even in the case of future deviations from the economic outlook. He essentially tied his hands, similar to the Greek hero Odyssey, who made his crew tie him to the ship, so he does not fall for the mermaids' temptations. That is why these two approaches are often referred to as Delphic forward guidance and Odyssean forward guidance. He also used more explicit language, mentioning a specific endpoint of the policy.
For more detailed analysis of the forward guidance of the US Fed, please look at the table below.
Forward Guidance Provided
"Patient in removing policy accommodation"
"Be removed at a pace that could be measured"
"Warrant exceptionally low levels of the federal funds rate for some time"
"Warrant exceptionally low levels of the federal funds rate for an extended period"
"At least through mid-2013"
Switched to State Contingent
One aspect that caught my attention is how inconsistent the Fed is regarding their future plans: they not only extended their time frame three times, but also switched from time to state-contingent monetary policy in late 2012. Of course, this incoherence is normal and almost expected, as the current unconventional policy is totally historically unprecedented. Furthermore, after all the recent GDP, inflation and unemployment revisions, we can conclude that even the leading economists work with highly imprecise data. These facts, however, raise the issue of Bernanke's credibility among investors and the effectiveness of his forward guidance.
Trigger vs. Threshold
When we talk about state-contingent Monetary Policy, we also need to discuss the difference between Trigger and Threshold, which people erroneously use interchangeably. As of today, the 6.5% unemployment and 2.5% inflation target rates are thresholds, meaning that the Fed did not commit to achieving, before they scale back their bond-buying program.
Transparency: How Much is Enough?
There are several scholars that discuss in detail the optimal forward guidance and how much information should the Fed disclose. Among those are Stephen Morris and Hyun-Song Shin: their findings are so important and popular that they are often referred to in other academic papers simply as M&S. Morris and Shin found that Fed's guidance is too significant in its effects on investors and this is the trouble: it very often distorts prices and drives them away from the fundamentals. This phenomenon is very visible especially nowadays, when investors react to positive economic data with sell-offs: bad news is good news. The perfect example is August 15, when the S&P500 (SPY) tumbled 1.4% on strong housing data. This reaction is natural and expected, but socially inefficient at the same time and increases the risk of asset bubble formation (Expect an article on this topic very soon).
The heightened sensitivity of today's market participants to Bernanke's statements should be evident to everyone and we, the investors, should be responsible for focusing on the cental bankers' actions, rather than their guidance. This plan is extremely simple and yet the most effecive way to fight the forward guidance uncertainty.
And as Peter Lynch said, "The simpler it is, the better I like it."