Central banks have made great strides in transparency over the past two decades. In particular, monetary authorities in the industrialized world have placed greater emphasis on what is now commonly referred to as “forward guidance.” As former Bank of Canada Governor and incoming Bank of England Governor Mark Carney put it recently, forward guidance essentially amounts to explaining “what central banks are trying to achieve and how they go about achieving it” (Carney, 2013). Whereas greater transparency sheds more light on why the central bank acts the way it does, forward guidance represents an explicit attempt to influence market and public inflation expectations by providing insights about the possible future direction of monetary policy.
Since the future is unknown, and with central bank policy rates currently near or at the zero lower bound, there is a premium on how central banks communicate their actions. In a recent speech, Jaime Caruana, general manager of the Bank for International Settlements, expressed this view: “At the current juncture, there is also a premium on central bank communication. Central banks need to clearly communicate the limits of monetary policy” (Caruana, 2013). This reflects an environment where there are growing concerns about the implications of historically low interest rates for an extended period of time.
While the role and potential benefits of forward guidance are not questioned, is it possible that central banks are taking it too far? The simple answer is yes. Originally, the promise of forward guidance was that it was seen as a natural extension of autonomous central banks wanting to be more transparent and, by implication, more accountable. Indeed, forward guidance is intended to put an explicit face on what it means for a central bank to be forward looking. Some might even say that its explicit aim is for central banks to “put their money where their mouth is.”
Forward guidance represents an evolution of sorts in the practice of central banking. Beginning in the early 1990s, efforts at improving transparency led central banks to rely on verbal signals to hint at any future bias in the stance of monetary policy. Most often this was reflected in the precise language used to communicate policy rate decisions via press releases. Examples include statements used by the US Federal Reserve to communicate the outlook for the stance of monetary policy, which included statements such as “the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time." [1]
Later, some central banks began to be more explicit about likely future policy rates by publishing forward interest rate paths. Until fairly recently, however, these forward paths provided only limited information about the future course of monetary policy since either constant interest rates going forward were assumed or the paths were conditioned on what financial markets believed would be the likely future course of interest rates. Today, central banks such as the US Federal Reserve, Norway’s Norges Bank and Sweden’s Riksbank publish forward rate paths conditioned on central bank staff forecasts or forecasts issued by members of the monetary policy decision-making committee.
Of course, even as some central banks became more explicit about the future course of the economy, that is, the likely evolution of interest rates, inflation and real economic activity, they were always careful to underline the point that, as facts change, so would the outlook for key macroeconomic aggregates. In 2009, however, the Bank of Canada took the conditionality of monetary policy one step further by explicitly making a commitment about policy rates for a specified horizon, namely up to one calendar year, subject to revisiting the commitment if the outlook changed and threatened the Bank’s remit of a two percent inflation target. In the event, in April 2010 the Bank successfully convinced markets that the outlook had changed sufficiently to remove the commitment before it was due to expire in June 2010.
It is notable, however, that the Bank of Canada’s conditional commitment (see Siklos and Spence, 2010, and He, 2010, for assessments) was based on nominal variables, that is, interest rates and inflation rates, and not real variables such as GDP growth or unemployment. In 2013, the US Federal Reserve adopted a form of conditional commitment when it agreed to maintain the current stance of monetary policy so long as the medium-term inflation target of two percent is not threatened and the unemployment rate remains above 6.5 percent. In so doing, the Fed strays directly into the central bank making commitments driven by a target for real economic performance.
Forward guidance, like that introduced by the US Fed, can lead to tension. Central banks are becoming more confident in their ability to deliver stable and predictable inflation — this comes up against pressure from politicians, markets and the public to do more to help economies around the world, but also ensure the advanced economies reach “escape velocity,” a concept that Carney (2013), in an earlier speech, borrowed from physics to justify the continued need for loose monetary policies. Commitments of this kind can be said to be consistent with the notion of “constrained discretion,” which is viewed by most economists as compatible with good monetary policy as well as with the idea that, in times of crisis, central bank communication ought to differ from the strategy adopted in normal times. There is, however, the danger that central banks are going too far and will end up confusing rather than clarifying what monetary policy can or cannot do.
The dangers of central banks basing the conditionality of their policies on real economic outcomes arise on both theoretical and practical grounds. Bullard (2013) provides a good summary of the theoretical objections raised by the Fed’s recent changes in the forward guidance it provides. When the Fed made its announcement, it did not specify whether the threshold of 6.5 percent for the unemployment rate was driven by the belief, held by the Federal Open Market Committee, that it was appropriate to aim for the pre-crisis state of the US economy. Indeed, if one believes an aging population, and the “low hanging fruit” of productivity-enhancing technological changes, conspire to a future of lower economic growth (see, for example, Gordon 2012), then it is far from clear that the pre-crisis state of economic activity is what we should aspire to. And if the pre-crisis state is inappropriate, then exactly what economic state should we aim for? Woodford (2012) demonstrates that these kinds of considerations affect both the credibility of and net benefits from exiting a state where monetary policy does not operate as usual.
Empirically, we know that economies can produce a wide range of unemployment rates consistent with price stability. Indeed, Staiger, Stock and Watson (1997), among others, have shown how imprecise estimates of the non-inflationary rate of unemployment are over time. Moreover, there is the added risk that any trade-off between changes in inflation and unemployment rates has also changed over time, rendering even less clear precisely what conditional commitments — of the Fed variety — can actually achieve.
Next, as several authors have pointed out (see, for example, Caruana, 2013 and Masson, 2013), there is a long-held tradition that monetary policy is governed by the view that it is neutral in the long-run, that is, it cannot influence the level of unemployment or output consistent with full capacity utilization or full employment. However, promises of the kind the Fed has made, even if they are conditional and carefully articulated, raise the possibility that the “do no harm” principle of monetary policy is being violated. Indeed, when central banks stray into the territory of making commitments on real economic variables, no matter how they are conditioned, they risk even greater political pressure and the consequent loss of autonomy when elected officials begin to question the chosen thresholds.
A conditional commitment such as the one the Bank of Canada pioneered in 2009 is not only appropriate, especially when the threat of deflation is looming, but also serves to put strict limitations on what a central bank can promise and over what period of time. This type of commitment also makes clear that monetary policy can only do so much to help an economy recover. A conditional commitment of the kind made by the Fed raises a host of questions that may well push monetary policy into perilous territory. However well intentioned the policy is, as well as being intended as a signal of the central bank adopting a “whatever it takes” attitude, which was essential during the height of the global financial crisis of 2008–2009, monetary policy cannot credibly make conditional commitments about real economic outcomes. We may well have entered, once again, an environment that Paul Volcker, former Fed Chairman, warned us about long ago: “Industrial nations, including our own, nowadays rely heavily — sometimes too heavily — on their central banks and on monetary policy to achieve our economic goals” (Volcker, 1984).
Some of the points expressed in this article appeared in a shorter-form op-ed published in the Financial Post in June 2013.
Works Cited
- Bullard, J. (2013). “Some Unpleasant Implications for Unemployment Targeters.” Presented at the 22nd Annual Hyman Minsky Conference, New York, NY, April 17.
- Carney, M. (2013). “Monetary Policy After the Fall.” Eric J. Hanson Memorial Lecture, University of Alberta, May 1.
- ——— (2013). “Canada Works.” Speech to Board of Trade of Metropolitan Montreal, May 21.
- Caruana, J. (2013). “Hitting the limits of ‘outside the box’ thinking? Monetary policy in the Crisis and Beyond.” Speech given to OMFIF (Golden Series Lecture), May 16.
- Gordon, R. J. (2012). “Is U.S. Economic Growth Over? Faltering Innovation Confronts Six Headwinds.” NBER working paper 18315. August.
- He, Z. (2010). “Evaluating the Effect of the Bank of Canada’s Conditional Commitment Policy.” Discussion paper 2010-11. August.
- Masson, P. R. (2013). “The Dangers of an Extended Period of Low Interest Rates: Why the Bank of Canada Should Start Raising Them Now.” C. D. Howe Commentary 381. May.
- Siklos, P. L. and A. Spence (2010). “Faceoff: Should the Bank of Canada Release its Projection for the Interest Rate Path?” C. D. Howe Backgrounder 134.
- Staiger, D., Stock, J. H., and M. W. Watson (1997). “The NAIRU, Unemployment and Monetary Policy.” Journal of Economic Perspectives 11, no. 1: 33–49.
- Woodford, M. (2012). “Accommodation at the Zero Lower Bound.” In The Changing Policy Landscape, Economic Symposium, Federal Reserve Bank of Kansas City.