Mark Carney's dangerous new forward guidance
Mark Carney has a name for the new framework for monetary policy he unveiled yesterday: “forward guidance phase two”. My first thought yesterday when I listened to him at the Bank’s press conference was that it would be better entitled “fuzzy guidance”. It is, after all, a far vaguer version of the guidance policy the Bank was following since last August.
But the more I think about it, the more I think this name underplays its weaknesses and its dangers. It strikes me that fuzzy guidance is yet another example of an insidious trend that has overtaken the world of central banking – one that was at least in part responsible for the crisis.
But before we get to that, let’s start with the basics. Whatever anyone tells you, there is nothing new about forward guidance. Since the very earliest days of macroeconomics, policymakers – whether central bankers or politicians – have had to grapple with two opposing demands. On the one hand they have to reassure people that the economy is in safe hands, and that they know what they’re doing. This involves giving them some indication of what to expect in the coming months and years, so that businesses and households can invest and spend with confidence.
On the other hand, the more explicit they are about the future path of economic policy, the more likely people will be to try to game it. If you commit to leaving interest rates low for a set period of time, you will almost certainly create a mini (or major) boom and bust as people borrow and spend with wild abandon until that deadline, and then shut up shop.
So throughout history central bankers have done their best to be as vague, and simultaneously as reassuring, as possible. This has had various different manifestations over time: Depression-era Bank of England Governor Montagu Norman was wont to tap the side of his nose slowly when asked what he planned for the UK economy. Alan Greenspan of the Federal Reserve attempted to tie his testimonies and speech up with as much jargon as possible while giving the impression that he was preternaturally in control of the US economy.
Since the beginning of central banking, every monetary policymaker has had to walk this tightrope, but all of them, in their own particular way, has dispensed a form of guidance to households and investors. Mervyn King’s brand was a peculiar one: when asked what the future path of interest rates was likely to be at a speech or press conference, he would respond that he and the Monetary Policy Committee would never pre-commit to a certain path. The Bank’s job, he occasionally added, was to keep inflation as close to its target as possible. And yet in the Inflation Report each quarter, the Bank would publish its own assessments of how close to target inflation would be, depending on a variety of scenarios for interest rates (the famous “fan charts”). By reading between the lines, you could work out whether the market was too hawkish (thinking rates were going up too much) or dovish (rates too low), and then adjust your expectations accordingly.
It may have been branded differently, and have been esoteric in the highest degree, but this was guidance plain and simple. Journalists and analysts would come away from each Inflation Report knowing that the Bank expected to leave rates lower for longer, or to lift them sooner than had been previously expected. Even within the Bank, officials would refer freely to a “tightening” fan chart or a “loosening” chart.
This served the Bank pretty well until the recent crisis, when a massive slide in economic activity came alongside a big rise in inflation. The overall economic picture was screaming that low interest rates were necessary; but the inflation target alone seemed to suggest that higher rates were needed (after all, higher rates usually push down inflation).
The Bank carried on with its semi-guidance. In its Inflation Reports from 2009 to 2013 the fan charts signalled that although inflation was indeed high, a rise in interest rates would put it well below target. It was plain enough to us economics journalists and city analysts what was going on: the Bank had no intention of raising rates any time soon. However, to those who paid less attention to this version of Threadneedle Street Kremlinology, the situation looked a little more confusing. Why, they asked, wouldn’t markets simply assume that rates would be yanked higher the moment the economy looked like recovering?
Which is where Mark Carney comes in. When the new Bank Governor came into office, at the Chancellor’s invitation he introduced a new version of Forward Guidance. The objective was the same as those fan charts: to reassure investors that even if inflation was above target, the Bank wouldn’t be lifting rates any time soon. However, rather than simply saying so outright, Dr Carney put this in econometric terms. He committed not to consider raising rates until the unemployment rate, then close to 8%, was down to 7%. This wasn’t supposed to happen for two years or so, based on the Bank’s forecasts. In the event it has happened in about six months. This was fortunate for the economy, but unfortunate for the Bank, which looked a little foolish. On the flip-side, inflation was, also against all expectations, back on target. So one reasonable conclusion might have been to ditch forward guidance and return to old-fashioned inflation targeting.
Which is, in a sense, what happened yesterday. The Bank signalled, in a way not unlike the Mervyn King version of guidance, that the market’s expectations for future interest rate movements were pretty reasonable (maybe a touch hawkish, but nothing massive). Unemployment-related forward guidance was pretty much declared over.
However, this was apparently not enough. The Governor also unveiled a whole new form of “guidance”. Quite what it is remains rather unclear, even to those of us who were there yesterday (hence the name “fuzzy guidance”). One explanation is that rather than predicating its future rate movements based on the unemployment rate, the Bank will instead focus on something called “spare capacity” – in short the extent to which the economy is growing at a rate below its long-term potential. In so doing the Bank published, for the first time, its estimate of the “output gap”, and this implied that there was some spare capacity now. This implies that rates don’t need to go up soon. He also said that when rates do rise they will do so only gradually, and won’t go up very far.
All of this is fair and well. However, it doesn’t really tell us anything new: the output gap is a deeply subjective and frankly obscure measure of economic potential, of little use to any but economic wonks. Whereas hinging monetary policy on the unemployment rate did indeed make it a little clearer to businesses that rates wouldn’t go up for at least a while, using the output gap is only likely to obfuscate things.
We always knew from market expectations for interest rates that borrowing costs weren’t likely to go up any time soon, and that they would only rise gradually. Having the Bank Governor reiterate that explicitly is all fair and well, but it doesn’t exactly tell us anything new. The same message could quite easily have been given using those old-school fan charts.
What’s insidious about fuzzy guidance is that it dresses up what could quite reasonably be old-fashioned vague reassurance, of the kind everyone from Montagu Norman to Mervyn King used to dispense, in purportedly scientific clothes. As part of fuzzy guidance, the Bank will monitor not one, not two, but eighteen different metrics. This cult-of-numbers variety of economics was one of the trends which contributed to the economic crisis in the first place, attributing a spurious scientific nature to forecasts and assumptions which were often simply guess-work.
The problem is that the Bank’s assessment of many of these 18 metrics, whether unemployment, the output gap or indeed GDP, is likely in time to be proved wrong. Its credibility will suffer as a result (it already has). This could well undermine confidence in its ability to manage monetary policy in the future.
Far better, as Andrew Lilico also argues today, to be what central bankers have always been: reassuringly vague.
UPDATE: The folks at the Bank have been in touch to emphasise that although the latest Inflation Report did indeed include 18 economic metrics the Bank is forecasting, these are not an integral part of forward guidance phase two. Instead, they merely represent more information on the Bank’s forecast, a response to the Stockton Review. While this doesn’t change my main thrust (that forward guidance is really just a resumption of old-school inflation targeting) it does suggest that the new form of guidance is less reliant on specific statistics than some suggested yesterday.