Mark Carney, the new Governor of the Bank of England, walks to a monetary policy committee (MPC) briefing. (AP Photo/Jason Alden/Pool)
Mark Carney, the new Governor of the Bank of England, walks to a monetary policy committee (MPC) briefing. (AP Photo/Jason Alden/Pool)

The Financial Times has an article, here, concerning Bank of England (BoE) Governor Mark Carney's policy of forward guidance. The article raises concerns that the policy could lead households and businesses to believe that current interest rate levels are "guaranteed." The danger, it suggests, is that the forward guidance policy increases the risk of distorting investment and sows the seeds of a future crisis (asset price bubbles). Problems will arise as financial markets are whipsawed when the BoE finally begins to raise interest rates.

While I appreciate these risks, I'm not sure the conclusion Governor Carney is to draw. To begin with, forward guidance does not "guarantee" that interest rates will reamain at current levels into the indefinite future. It is, rather, a conditional commitment to maintain interest rates at current levels until there are clear signs of recovery. In this respect, forward guidance is contingent on the state of the economy, as is the case with any monetary rule, on reflection. These state variables trigger a policy response. The advantage of forward guidance and its principle recommendation is that it provides greater clarity on what these triggers are.

This clarification is especially important in the current environment. Pervasive uncertainty creates an option value of waiting — if individuals are confused about the basic underlying structure of the economy and how it is likely to evolve, they may defer financial decisions; waiting for the mists of uncertainty to dissipate before acting. The result is that investment is deferred and consumption postponed. Of course, isolated cases of individuals exercising the option value of waiting can be thought of as prudent, rational behaviour, with little impact on the aggregate economy. But if everyone thinks in the same way and behaves in this manner, the outcome is protracted stagnation which makes everyone worse off: in effect, what is individually rational becomes collectively irrational.

In such circumstances there can be a role for monetary policy to help coordinate the actions of atomistic agents by providing greater clarity on the very short-term interest rate —  a key relative price in the economy. (Interest rates are the relative price of current versus future consumption.) The seminal article here is Paul Krugman's "Capital Hill's Baby Sitting Co-op," a non-tecnical, yet highly informative allegorical tale that clearly explains the role of money and monetary policy.

There may indeed be risks from the extraordinary measures, such as forward guidance, that many central banks have adopted. But we are not in normal times. The spectre of sustained stagnation haunts the global economy and large adjustment challenges remain. In this conjuncture, what is Governor Carney to do?

The opinions expressed in this article/multimedia are those of the author(s) and do not necessarily reflect the views of CIGI or its Board of Directors.
  • James A. Haley is a senior fellow at CIGI and a Canada Institute global fellow at the Woodrow Wilson Center for International Scholars in Washington, DC.