With Mark Carney en route to the Bank of England and expectations running high that his success in Canada can be replicated in the U.K., now is a good time to revisit central banks’ experiment with forward guidance. Forward guidance represents an explicit attempt to shape expectations by providing insights about the possible future direction of monetary policy. Since the future is unknown there is a premium on how central banks communicate their actions. This is particularly true nowadays as central bank policy rates are near or at the zero lower bound. These developments are taking place in an environment where there are growing concerns over the implications of historically low interest rates for an extended period of time. Is there a possibility that central banks may take forward guidance too far? The simple answer is yes.
Central banks are always careful to underline that, as facts change, so would the outlook for key macroeconomic aggregates. In 2009, the Bank of Canada took the conditionality of monetary policy one step further by explicitly making a commitment about policy rates for up to one calendar year, subject to revisiting the commitment if the outlook changed and threatened meeting the inflation target. 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.
Conditional commitments represent the latest efforts at improving transparency. Well over a decade ago central banks began to rely on verbal signals to hint at any future bias in the stance of monetary policy. More recently, some central banks have become more explicit about likely future policy rates by publishing forward interest rate paths. A few central banks, including the U.S. Federal Reserve, even publish forward rate paths conditioned on forecasts published by members of the monetary policy decision-making committee.
The Bank of Canada’s conditional commitment was based on nominal variables, that is, interest rates and inflation rates, and not real variables such as unemployment. In 2013 the U.S. Fed under Chairman Ben Bernanke adopted a new kind of conditional commitment when it agreed to maintain the current stance of monetary policy so long as the medium term inflation target of 2% was not breached and the unemployment rate remains above 6.5%. In so doing, the Fed strays directly into the central bank making commitments driven by a target for real economic performance.
The Fed did not specify whether the threshold of 6.5% for the unemployment rate is driven by a belief that the pre-crisis state of the U.S. economy was the one the Federal Open Market Committee (FOMC) is aiming for. Indeed, if one believes an aging population, or the “low hanging fruit” of productivity enhancing technological changes, are disappearing then it is far from clear that what we should aspire to is the pre-crisis state of economic activity. And if the pre-crisis state is inappropriate then exactly what economic state should we aim for?
Experience indicates that economies can produce a wide range of unemployment rates consistent with price stability. Estimates of the non-inflationary rate of unemployment over time are highly imprecise. Moreover, there is a long-held tradition that monetary policy is governed by the view that it is cannot influence the level of unemployment or output consistent with full capacity utilization or full employment. 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. When central banks stray into the territory of making commitments, no matter how they are conditioned, on real economic variables they risk even more political pressure and the consequent loss of autonomy when elected officials begin to question the chosen thresholds.
A conditional commitment of the kind 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 kind 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, and intended as a signal of the central bank “doing whatever it takes” (an attitude which was essential during the height of the global financial crisis of 2008-2009 and has since been emulated by the Bank of Japan), monetary policy cannot credibly make conditional commitments about real economic outcomes. Paul Volcker, former Fed Chairman, reminded us 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.”
Pierre Siklos is a senior fellow at The Centre for International Governance Innovation.