Canada Says Forward Guidance Useful Only During Crises

Monetary Policy Week in Review: 20-24 October 2014

by Peter Nielsen, Central Bank News

Last week five central banks maintained their policy rates with the Bangko Sentral ng Pilipinas (BSP) the latest monetary authority to drop a hawkish bias or ease policy in response to waning inflationary pressures from the drop in commodity prices, especially energy, since June. Canada and Norway’s central banks also took note of the weaker global economy, with economists speculating Norges Bank in December will once again delay or weaken its plan to raise rates in 2016.

The Bank of Canada’s (BOC) policy statement was notable because it reflected the governor’s decision to drop the use of forward guidance in more normal economic times and instead be fully transparent about the risks the central bank is weighing as part of its policy deliberation. In its September policy statement, the BOC said it was “neutral” with respect to its next rate change, with the timing and direction of future changes depending on the outlook.

Last week’s policy statement didn’t change the essence of that guidance as the BOC’s outlook for inflation hadn’t shifted since its July forecast so the practical consequence on market rates of the BOC’s new policy about forward guidance has yet to be seen.

But the BOC’s thoughts about forward guidance are likely to be scrutinized by other central banks because it broke new ground in April 2009 when it pledged to keep rates at what it considered to be zero through the second quarter of 2010 in order to provide additional stimulus in the depth of the global financial crises.

In his speech on Oct. 15, BOC Governor Stephen Poloz argued that such guidance is useful in times of crises because it can help flatten the yield curve by reassuring markets about the horizon over which it expects to keep rates at zero, enhancing the economy’s response to the bank’s low policy rates.

But the downside of such guidance is that it essentially gives markets a one-way bet, Poloz said. As major market participants use increasing amount of leverage the longer the guidance remains in place, volatility tends to surge when the central bank is suddenly seen changing this guidance. This was clearly the case in May 2013 when the U.S. Federal Reserve first announced it was considering scaling back quantitative easing, a move that unleashed a major shift in global capital away from emerging markets.

The second downside for Poloz is that the forward guidance is inevitably conditional on assumptions and forecasts so central banks end up insert certain caveats into their guidance. This creates a fragile market equilibrium. Every new piece of economic data may be interpreted as a caveat so financial markets end up needing “repeated doses of reassurance.”

Poloz said:

“In short, forward guidance can become addictive for markets if it is overly precise or heavily weighted with caveats.”

His conclusion is that forward guidance is a useful tool at the zero lower bound because it removes a key source of uncertainty for markets about future policy rates. But by dropping its guidance, the central bank is shifting some of the uncertainty about an economy’s evolution back on the market, helping ensure a more balanced two-way market that is less vulnerable to unusual leverage and volatile shifts in sentiment.

As witnessed by the scrutiny of the Federal Reserve’s “dot” forecasts for the fed funds rate in recent months, Poloz said financial markets typically want central bankers to be specific in their forecasts and then expect any deviation in forecast from actual data to have a clear implication for monetary policy.

But Poloz argued that central bankers always grapple with uncertainty in deciding on policy and this has only worsened in the aftermath of the global financial crises. The BOC is thus likely to become more transparent about the assumptions surrounding its forecasts and clearly point out the fundamental uncertainties and policy risks it is facing.

Poloz said:

“The idea is simply to inject a little more realism about uncertainty into the narrative, while trusting markets to wrestle with the data flow and deliver two-way trading”

Through the first 43 weeks of this year, the 90 central banks followed by Central Bank News have cut their policy rates 53 times, or 13.6 percent of this year’s 390 policy decisions, up from 12 percent at the end of the first half and 12 percent at the end of the first quarter.

Meanwhile, rates have been raised 38 times, or 9.7 percent of all policy decisions, up from 9.3 percent at the end of June and 8.7 percent at the end of March. LIST OF LAST WEEK’S CENTRAL BANK DECISIONS:

• Namibia holds rate but still concerned over credit growth
• Canada maintains rate on balanced risks to inflation
• Norway holds rate, no guidance for same rate by end-’15
• Philippines holds rate, sees lower inflation 2014-2016
• Turkey holds rates, tight stance until inflation improves

TABLE WITH LAST WEEK’S MONETARY POLICY DECISIONS:

This week (Week 44) 14 central banks or monetary authorities are scheduled to decide on monetary policy: Angola, Israel, Mauritius, Sweden, Hungary, the United States, Brazil, Albania, New Zealand, Fiji, Russia, Mexico and the Eastern Caribbean Central Bank (ECCB). TABLE WITH THIS WEEK’S MONETARY POLICY DECISIONS:

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