“FORWARD GUIDANCE’: Is it enough?

Recently, the world’s most important Central Banks – in their efforts to stem the financial/economic crisis – have abandoned their “spot” market guidance, and have adopted so-called “forward guidance”: instead of – as was usual – pronouncing on the present economic situation and adjusting their interest rates to that, they attempt to steer markets into a more growth-oriented direction by signaling that they will maintain lower than previously justified interest rates for some time to come. This is part of “unconventional instruments”, adopted in their (Central Banks’) more prominent role to also promote growth, in addition to their more conventional task of preventing inflation.

Most outspoken is the US Fed which stated earlier that it would maintain its bond purchasing program (of 85 bill $ a month) until the unemployment rate had fallen to around 6.5%. This is unusual insofar, as the direct influence of the Fed’s policies on unemployment is less than clear. The Bank of Japan’s announcement of pumping money into the economy until the inflation rate moved up to 2% is more “traditional”, but still unusual in its means – and again is “forward looking” giving indication of Bank behavior into the future. The new governor of the Bank of England, the Canadian Mark Carney, before his appointment had been an advocate of targeting Central Bank policy towards the nominal GDP growth rate (for the layperson: the product of real GDP and inflation) in his first meeting of the UK Monetary Policy Committee this month, came out less clear, but also with a statement that present policy would be maintained for a while. And most recently, the European Central Bank, whose governor Mario Draghi a year ago had stunned the financial world by stating that ECB would do “everything” to support the economy, has also stated – for the first time – that they would maintain their accommodative policy “for the time being”. 

There are advocates of economic targets, like the Fed’s 6.5% or Carney’s previous nominal GDP growth measure as benchmarks, there are also advocates about a more vague statement, like “for the time being” or “in the near future”. The former do suggest that there is a direct link between Bank policy and the chosen economic target, the latter suggest the existence of a “black box”. While the latter – spoken as an economist – is closer to “economic truth”, because all more usual channels between monetary policy and the real economy seem to have broken down, the former gives clearer guidance. But the “markets”, i.e. the financial institutions, seem to be quite giddy about this new forward guidance, as the recent market turmoil showed when Fed President Bernanke hinted that “soon” the Fed would “taper”, i.e. reduce, their bond purchasing program.

The overall picture of the industrial world’s monetary policy is mixed. This shows that there is no consensus in how to combat the crisis. While in the US and Japan expansionary monetary policy is to some extent supported by expansionary fiscal policy (in the US at least until last year, now because of “sequestration” fiscal policy is highly contractionary), in the Eurozone and the UK the burden of growth/supporting measures lies exclusively with the Central Banks. Government budgets are highly contractionary. Budget deficits as a percentage of GDP have been falling for years, while the debt ratios – the declared target of fiscal policy – are still rising (also because of hardly growing or contracting GDPs). In this sorry European situation, it is to be welcomed that the ECB tries unconventional policies to maintain demand, but – as stated above – the transmission channels of this liquidity tsunami and the symbolic “lender of last resort” statement by Dreghi a year ago into the real economy are blocked. Whether more liquidity can help this situation is very doubtful, as the recent past shows.

What would be needed, is twofold. A coordinated macroeconomic policy mix – both relating to expansionary fiscal and monetary policy – needs to be developed urgently for the Eurozone and the EU. It has become sufficiently clear during the past years that the present – contradictory – policy mix does not work, but drives the EU and EZ economy into a downward spiral with severe economic, social and political costs in the crisis countries, but also widespread dissatisfaction in the more stable countries.  Much of the ECB’s liquidity provision at ultra-low interest rates has gone into equity bubbles and bond purchases, instead of into the real economy, where more and more businesses decry a severe credit crunch. Fiscal policy must take on its appropriate role in this debate, stimulating growth in the short run to get the “animal spirits” moving again, and developing the longer-term instruments to get to debt ratios down towards sustainable levels. The second omission is the lack of a “grand plan” for the financial sector. The EU’s piecemeal approach towards a necessary Banking Union, one step forward, one halting, one backwards, is not getting the financial sector in shape for its future functionality and tasks.

The EU institutions’ tunnel vision – the Treaty is the bible which must not be tempered with – is preventing a more structured and effective approach. While many individual steplets have been taken (using up an extraordinary amount of effort an time), the vision for the future is not visible. This hurts “markets”, businesses and consumers and keeps the economy mired in a depression spiral. “Structural reforms” while necessary in many EU countries, alone will not generate growth. They need to be supported by an expansionary macroeconomic policy mix, in order to unleash the restrained economic forces. Six pack, two pack, fiscal pact and all these worthy instruments are not helping. The country-by-country approach of the Commission and Council prevents the EU/EZ from looking at the  European area as a whole and support the area with the appropriate economic policies.




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One response to ““FORWARD GUIDANCE’: Is it enough?

  1. kurtbayer

    In the meantime, one month later, the Bank of England governor has issues his guidance, but both in the UK and in the US the addressees, i.e. the “markets” do not seem convinced by this new instrument. the scour each new data set and speculate whether any green shoot, any unexpected development, will trigger an premature end to the extra-loose monetary policy. They now “price in” earlier than Bank-announced interest rate rises, thus obviating the intended effect of “forward guidance”.
    This may be due to the escape clauses and actions taken by the respective governors: the UK’s inflation rate clause (there the official target, 2%, has not been reached for several quarters, as the UK inflation rate has hovered around 3% even during the deep recession), in the US, Bernanke’s announcement a few weeks ago that “tapering” of the asset-purchase program might occur soon has rattled the bond markets all over the world, even after he backtracked a few days later.
    I would agree with commentators that these developments do not speak against this new instrument per se, but that a) escape clauses are problematic, because they leave the purpose of the guidance ore or less in the open (and, to speak the truth, no governor would forego to react to new developments if he (and his relevant committee) deemed it necessary; and b) that once forward guidance has been issued, governors need to be even more careful about what they say in the public. Their intention and the perception of investors are two different pairs of shoes.
    My own take would be, however, that these recent developments which seem to render forward guidance ineffective, show once more that the subjugation of fiscal and monetary policies to the very fragile perceptions of the markets should be a waking call to start a serious debate about who in the end should finance public budgets (beyond the taxpayers). I reiterate my call for Central Banks to take over this important public good from the private financial markets, of course with effective safeguards that this does not lead to politically motivated unhindered self-service financing of politicians’ pet projects.

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