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Special Topic: Forward Guidance on Monetary Policy

Since 2008 many central banks in advanced economies have been explicitly indicating their future monetary policy intentions. Explicit forward guidance (FG) about why and how long they plan to continue with their monetary stimulus is intended to avoid market interest rates increasing earlier than required. This change has been useful in providing additional information about the unconventional monetary stimulus that has persisted long after the global financial crisis (GFC) in many advanced economies. Before the GFC, the Reserve Bank of New Zealand (RBNZ) (along with Sweden's Riksbank and Norway's Norges Bank) was in the small minority of central banks that published FG in the form of interest rate forecasts. Now central banks which are constrained with policy rates close to zero are using FG as a monetary tool to manage long-term interest rates.

This note introduces the different forms of FG that have been used by central banks since the GFC, their merits and disadvantages, and a comparison with FG in New Zealand. Two key points emerge. First, central banks have been adapting their FG as they face the challenges of communicating the likely conditions for continuing with their monetary stimulus. Second, more recently the RBNZ has been providing time-contingent forward guidance on its policy rate, supplementing its regular interest rate projections, in response to the GFC, Canterbury earthquakes and rapid increases in house prices.

The concept of forward guidance

FG shapes future interest rate expectations

Central banks now use FG to indicate in words their future monetary policy stance (policy rates and quantitative interventions) conditional upon the economic outlook. By announcing their future monetary stance, central banks aim to influence expected short-term interest rates that are a key component of long-term rates. It is mostly those central banks with short-term policy rates constrained at the effective lower bound since the GFC in 2008, and which wish to continue with their current stimulus, that are using FG to push down long-term interest rates. On the other hand, FG, in terms of published interest rate forecasts, is merely intended to form an input into the market's interest rate expectations rather than to actively influence them.

The key challenge for central banks in managing long-term interest rates is that the markets believe in the FG, while the central banks themselves do not pre-commit to a stance that they have to retract later (Woodford, 2013). When stimulus drives inflation above target, markets tend to expect the central banks to renege on their FG. Equally, managing an orderly unwinding of the stimulus during the economic recovery phase without market disruption through FG also remains challenging for these central banks.     

The forms of forward guidance

FG evolved from open-ended to time-contingent and to state-contingent guidance in the major advanced economies

Since the GFC, central banks have adopted three forms of FG to specify the duration of their current stimulus depending upon the stage of the crisis in their economies.  The central banks in economies in deep crisis (Bank of Japan and the European Central Bank) have maintained open-ended time commitments for continuing with their monetary stimulus since they were uncertain when the recovery would start. This open-ended stance has provided them with flexibility to respond to unforeseen developments, but the ambiguity of such a stance makes it difficult to interpret.

The central banks which are more certain about their economic recoveries (the Bank of Canada and Riksbank) have provided time-contingent guidance by specifying the date until which they intend to continue with monetary stimulus. However, such guidance may not be credible if economic conditions change close to that date, making markets uncertain how central banks would respond. To make their guidance more credible, the central banks which are more certain about the stage of recovery in their economies [US Federal Reserve Board (Fed) and Bank of England (BoE)] have tied reviewing their expansionary stance to an indicator, such as the unemployment rate crossing a threshold value, that can provide a warning about stretched supply capacities before inflationary pressures set in (Table 1).

Table 1: Forms of forward guidance

Table 1: Forms of forward guidance

 

Open- Ended

Time-Contingent

State-contingent

Nature

Indicates qualitatively the future monetary stance and broadly the conditions for change.

Indicates a future date for a review of the stance.

Ties the review of the stance to economic outcome once the chosen indicators cross their threshold values.

Merit

Allows flexibility in response.

Simple to interpret.

Helps market to update expectations.

Demerit

Difficult to interpret.

May not be credible if economic conditions change closer to that date.

May be difficult to interpret if the public is unaware of current values of indicators.

Central banks (Date adopted)

Bank of Japan (April 1999); Federal Reserve (August 2003); European Central Bank (July 2013).

Bank of Canada (April 2009); Riksbank (Sweden) (April 2009); Federal Reserve (August 2011).

Federal Reserve (December 2012);

Bank of England (August 2013).

Source: Bank of England (2013)

Since the GFC, the Fed's FG progressed from an open-ended stance in December 2008 to a time-contingent stance in August 2011 and to state-contingent guidance in December 2012. At that time it kept the threshold for the unemployment rate at 6.5% for reviewing its current stance subject to the medium-term inflation projection being not more than 2.5%.

The BoE introduced FG in the state-contingent form in August 2013. It  kept the threshold target for the unemployment rate at 7% for reviewing its expansionary stance, subject to the achievement of medium-term price stability (expected CPI inflation 18-24 months ahead of not more than 2.5% and medium-term inflation expectations being anchored) and financial stability conditions (controllable by supervisory and regulatory tools).

Problems in using the unemployment rate as a guide for state-contingent FG surfaced when rapid falls in the unemployment rates in the US and the UK were driven by people withdrawing from the workforce rather than increases in employment. This led both the Fed and the BOE to link their forward monetary stance to multiple indicators.

Three factors have made FG more challenging than originally anticipated.  First, in order to keep real long-term rates low, central banks have maintained higher than normal inflation targets for longer than markets would normally accept. Second, inflation is becoming less sensitive to output contractions and rising unemployment (IMF, 2014). Central banks initially included the unemployment rate, but then had to include other labour market indicators in order to monitor capacity utilisation more accurately. Financial indicators have also been included to monitor pressures on financial stability. Third, central banks have realised that they have to distinguish their guidance for the policy rate and quantitative stimulus. Addressing these issues, central banks, particularly the Fed and the BoE, have updated their guidance in recent months. As a result, the forms of FG are again becoming more open-ended about how long the central banks will continue with their stimulus.

The RBNZ has been providing FG in the form of interest rate forecasts and monetary policy judgements but has not used indicator-based guidance other than the inflation target

Since June 1997 the RBNZ has regularly published the interest rate (90-day bank bill rate) forecasts that it considers consistent with keeping inflation within the target range over the medium term.  By doing so, it commits to the inflation target and quantifies the required future monetary policy adjustments. Alongside this, the RBNZ has given equal importance to the qualification of the risks surrounding those interest rate forecasts for shaping  expected interest rates.

Since 2008 the RBNZ has also conveyed explicitly its judgements about future policy rates and their determinants as the New Zealand economy was hit by both domestic and international economic shocks. The judgements mattered for shaping interest rate expectations, particularly as the RBNZ kept the Official Cash Rate (OCR) unchanged at a historically low level for three years. The FG in those judgements played a key part in the RBNZ's signalling the timing of the OCR hike that occurred in March 2014.

In some of its previous forward guidance, the RBNZ made explicit comments about the likely future track of interest rates; for example, in its March 2009 response to the GFC, it indicated that future OCR cuts would be smaller with no likelihood of reaching zero lower bound; in its response to the Christchurch earthquakes in March 2011, it stated that the OCR reduction was an insurance against near-term negative effects on the economy; in March 2013, it said that the OCR would remain unchanged until the end of the year; in December 2013, it said that demand and inflation pressures should warrant a withdrawal of stimulus beginning in 2014; and in March 2014, that the OCR will need to increase by 200 basis points over the next two years.

Through the above policy judgements, the market became more certain about the timing and the extent of the OCR tightening. Notably, however, the RBNZ has refrained from explicitly tying future monetary policy intentions to any economic indicators other than inflation.

The RBNZ is now giving guidance on the impact of the housing loan restrictions on monetary policy 

The RBNZ coordinates the use of monetary and macro-prudential policies, formalised through the Policy Targets Agreement, 2012 and the Memorandum of Understanding on Macro-prudential Policy, 2013. Monetary policy targets price stability and macro-prudential policy targets financial stability, but the two are coordinated to better achieve each other's objectiveswithout compromising their own primary objectives.  The RBNZ guides the extent to which its interest rate forecasts are based on support from macro-prudential policies or, in turn, support the latter's financial stability objective.

Accordingly, the RBNZ avoided increasing the OCR earlier than otherwise warranted, since the prudential policies restricting high loan-to-value ratio (LVR) mortgage lending, which it introduced in 2013 to dampen house price inflation and credit growth, were also expected to reduce the associated wealth and credit effects on overall demand and CPI inflation. After the RBNZ started its OCR tightening in March 2014, the LVR restrictions are expected to dampen house price inflation and reduce the CPI inflation pressures, similar in effect to a 25-50 basis points increase in the OCR (Spencer, 2014). With assistance from financial stability policies, a lower OCR would be required for targeting inflation.  Conversely, progressive OCR increases are likely to dampen house price inflation and help in phasing out the LVR restrictions in a timely manner. This coordination is expected to increase the efficiency of the conduct of monetary policy.

The efficacy of forward guidance

More specificity in FG increases certainty around the monetary outlook but reduces the flexibility of central banks

With more specific guidance, a central bank reduces uncertainty but also increases the chances of a loss of credibility if it deviates from its indicated monetary stance at the trigger dates or as the indicator values are approached. If the market misinterprets time and threshold amendments, then FG would fail to shape long-term interest rates as expected. For instance, when the Swedish Riksbank cut its policy rate in April 2009 and projected it to remain unchanged until 2011, the market rates went up as the reduction in the policy rate was less than was expected. When the Fed did not taper its asset purchases in September 2013, as was widely expected, it confounded the market. After contrary market reactions, these two central banks amended their FG to regain market credibility for their monetary stance. Regardless of the form, what matters is that central banks convey the conditionality and possibility of change in the FG settings credibly. To ensure credibility, the RBNZ has been issuing quantitative and qualitative forms of FG consistent with its inflation mandate.

FG impacted long-term interest rates during the crisis and is expected to remain effective during normal times as well

Barring a few episodes, studies show that markets have reacted similarly to FG and quantitative easing (QE), and policy rate announcements in the advanced economies during the GFC (IMF, 2014). FG backed by QE reduced long-term bond yields, and FG is expected to remain a useful monetary policy tool even in tranquil times. For New Zealand, the market impact of the RBNZ's interest rate projections was found to be relevant up to two quarters into the future, with the impact reducing after the outbreak of the global financial crisis (Detmers and Nautz, 2012). The RBNZ's use of FG to convey monetary policy judgements on the OCR, as a supplementary tool to its interest rate forecasts, could provide additional information to the market on the interest rate outlook. Also, the RBNZ will be able to rely on FG more readily in the future to communicate how the OCR and macro-prudential instruments are likely to be coordinated in pursuit of price stability and financial stability objectives respectively.

Conclusion

Since the GFC, central banks in major advanced economies with policy rates at the effective lower bound have been using FG to communicate their intentions about the turning points in their future monetary policy. Second, FG forms evolved from open-ended to time-contingent and state-contingent guidance aiming at increasing market certainty around the monetary outlook. However, as the monetary stimulus has persisted in these economies, guidance is again becoming more open-ended in terms of an indicator watch-list to signal a change in monetary stance. Third, the RBNZ provided time-contingent forward judgements about the OCR as the New Zealand economy was hit by the GFC and Canterbury earthquake shocks. These judgements supplemented its regular FG in terms of interest rate forecasts and  have been useful in shaping market expectations, especially in the light of the OCR remaining unchanged for three years, as well as signalling the impending hike that occurred in March 2014. The RBNZ is also providing FG on coordination of monetary and prudential policies in the context of LVR restrictions implemented to restrict home lending and house price increases. 

While it is too early to evaluate the efficacy of FG, studies show that FG and QE together have been successful in influencing long-term interest rates during the global financial crisis. FG is expected to remain useful as policy rates rise back to normal levels. For New Zealand, as judgements about monetary policy supplement the regular forecasts, it is expected that FG would increase the efficiency of the conduct of monetary policy.

References:

Bascand, G. (2013), 'Communication, Understanding and Credibility', December, RBNZ.

Bank of England (2013), Monetary Policy Trade-offs and Forward Guidance, August.

Bayoumi, T, G. Dell'Ariccia, K. Habermeier, T. Mancini-Griffoli, F. Valencia (2014), 'Monetary Policy in the New Normal', IMF Discussion Note, April.

Detmers, G-A and D. Nautz (2012), 'The Information Content of Central Bank Interest Rate Projections: Evidence from New Zealand', RBNZ Discussion Paper, RBNZ.

Federal Reserve Board (2014), Monetary Policy Press Release, January.

Goldman Sachs (2013), A Guide to Guidance, October.

Justiniano, A, C.Evans, J.Campbell and J. Fisher (2012), 'Macroeconomic Effects of FOMC Forward Guidance', Brookings Papers on Economic Activity, Spring.

Reserve Bank of New Zealand (1997), 'The Forecasting and Policy System: An Introduction', Reserve Bank Bulletin, Vol. 60 No.3.

----  (2009-2013), Monetary Policy Statement, December.

Spencer, G (2014), 'Coordination of Monetary and Macro-Prudential Policies', March, RBNZ.

Wheeler (2013), 'Forward Guidance could damage Central Banks', Radio New Zealand News, October.

Woodford, M (2013), 'Interview with Michael Woodford', Top of Mind, Issue 18, Goldman Sachs Economics and Strategy Research, October.

Notes

  • [1] Central banks are using both FG and quantitative easing (QE) to influence long-term rates. FG focuses on reducing expected short-term rates, while QE aims to lower long-term rates by reducing the term premia. Under QE, central banks buy assets and increase the funding available in the financial system.
  • [2] These forms of FG publicly commit central banks to a future policy rate stance ('Odyssean'), and differ from those showing merely central banks' macroeconomic forecasts and their likely policy actions ('Delphic') (Justiniao, et.al 2012).
  • [3] In December 2008, the Fed indicated that "weak economic conditions" were "likely to warrant exceptionally low levels of the Federal Funds rate for some time." In August 2011, it specified the time period for keeping its policy rate exceptionally low to "at least through mid-2013". In December 2012, it indicated that it would keep its policy rate exceptionally low until unemployment rate reached 6.5% subject to inflation projections of no more than 2.5% between one and two years out and evidence of well anchored long-term inflation expectations.
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