The role of the Financial Policy Committee in warning on the build-up of any bubble could be just as vital to the success of UK forward guidance as that of the Monetary Policy Committee.
As Bank of England governor Mark Carney has discovered, providing ‘forward guidance’ on economic policy is no easy task.
The US Federal Reserve is also wrestling with this conundrum. In addition, it has had to contend with soft (albeit weather-beaten) economic data and the extent to which it will continue tapering stimulus measures. But forward guidance is not in itself a post-crisis innovation.
Since the late 1990s, several small, inflation-targeting economies (including Sweden, New Zealand and Israel) have regularly published forecasts for their policy interest rates. Forward guidance in the context of very low interest rates was first adopted by Japan in 1999. However, the reach and influence of forward guidance has certainly increased since the financial crisis.
The aim of the most recent type of forward guidance has been to increase the effectiveness of monetary policy when interest rates are close to their ‘zero lower bound’ or floor level. A recent Bank for International Settlements (BIS) study has found that the approach “has been helpful in clarifying policy intentions in highly unusual economic circumstances”.
By reducing the volatility of near-term expectations about the path of interest rates – either through guidance based on unemployment rates (the Fed and the Bank of England), broader verbal guidance (European Central Bank) or by targeting the monetary base (Bank of Japan) – the BIS study suggests that guidance has clarified central banks’ policy intentions for financial markets. Thus Mark Carney, for one, has pronounced forward guidance a success.
But as the global economy slowly recovers, forward guidance is facing a number of new challenges. First, weaning markets off highly specific guidance – generally based on numerical thresholds – is not going to be easy.
The Fed, for example, is walking a fine line between signalling the end of exceptional monetary policy and avoiding another ‘taper tantrum’ similar to last summer’s.
In addition, clear guidance is difficult when decisions are made by committee. The BIS study notes that the compromises inevitable in such decision-making could “water down the clarity and credibility of guidance”.
In a recent Monetary Policy Committee (MPC) appearance before UK government officials, for example, it became clear that neither Mr Carney nor MPC member Martin Weale agreed with the committee’s published view that the UK economy currently has spare capacity equivalent to roughly 1-1.5 per cent of national income. This disagreement casts doubt on the MPC’s latest forecasts as a means of divining when rate rises are likely.
Such concerns could make it tempting to delay the ‘normalisation’ of policy, but this would be potentially dangerous. If those setting monetary policy were to become increasingly concerned about avoiding adverse market reactions (such as the taper tantrum), foot dragging on the withdrawal of stimulus could increase financial-stability risks. Thus the role of the Financial Policy Committee in warning on the build-up of any bubbles – particularly in the housing market – could be just as vital to the ultimate success of UK forward guidance as that of the MPC.
It is expected the Fed will draw its asset-purchase policy to a close before the end of this year, with the first rise in US policy interest rates coming by mid-2015. The Bank of England looks to be on a similar rate-raising timetable, with the European Central Bank and Bank of Japan some way behind. We may not be ‘normal’ yet, but we are slowly getting there.
Lucy O’Carroll is economist at Aberdeen Asset Management
