Central Bank Response Phase I: Buy! Buy! Buy!
Expanding central bank balance sheets was the policy tool of choice to support liquidity-impaired financial intermediaries and key capital markets. Central banks have collectively focused on strengthening intermediation and capital market functions through the following actions: 1) expanding the traditional lender-of-last-resort role to financial intermediaries suffering from heightened counterparty risk, weakened balance sheets, and deposit outflows; 2) providing liquidity to non-bank financial firms (e.g. securities firms); and 3) promoting purchases of longer-lived assets with higher risk characteristics. Unfortunately, central bank large-scale asset purchases (LSAPs) cannot continue indefinitely because of induced distortions in asset markets that increase risks to financial stability as the lack of diversity among market participants impairs pricing and reduces the capital markets’ ability to perform proper price discovery and allocate investments efficiently. In addition, the increased risk taking in asset allocation decisions under these distorted conditions may be sowing the seeds for the next crisis and increasing financial stability risks and vulnerabilities globally.
Central Bank Response Phase II: Please Believe Us
Forward guidance is the latest unconventional instrument that central banks wield to reassure global markets that sufficient monetary easing will be maintained to sustain robust non-inflationary growth. As nominal interest rates remain at the ZLB, central banks hope to influence expectations about the path for future market rates with statements about the path of future policy rates. Central banks have tried to spur growth by communicating to the public that policy rates would be lower, and for a longer period than would otherwise be the case given their past behavior. They must be especially convincing that policy has eased and that old rules, behaviors, and responses can no longer accurately forecast future policy.
Credibility is the linchpin for the successful use of forward guidance as a policy tool. If the public believes in the durability of the commitment, and comes to expect that the lower policy rates would lead to faster growth, higher employment, and higher income in the future, then precautionary saving would decline and current consumption and investment would rise. Successful forward guidance can create a virtuous feedback look, where the central banks’ promise of better future economic conditions (i.e., income and profits) actually boosts current activity.
Central Bank Phase III: Whoops, Change of Plans!
Unfortunately, central banks have strong incentives not to implement policies as announced through forward guidance, especially when interest rates hug the ZLB. The main goal for central bank forward guidance is to induce expectations about the future that changes current behavior in such a way as to generate more aggregate demand. Once the recovery begins to strengthen and becomes sustainable, it would be in the interest of the central bank to raise interest rates and reduce scheduled asset purchases more quickly than announced. The more successful is forward guidance in stimulating growth and employment, the greater the incentives for central banks to end the easing policy early.
An earlier-than-expected end to monetary easing would enhance the central bank’s inflation-fighting reputation, and reduce risks to financial stability. However, doubt or disbelief in the central bank’s commitment to the announced policy saps forward guidance of its effectiveness and its power to stimulate growth. Damaged credibility will likely limit the central bank’s willingness and ability to engage in forward guidance. The loss of credibility and ruined reputations imply that central banks could only renege once because no one will believe them again. Yet, history is replete with counterexamples.
The inability to bind future generations of policy makers to old promises also reduces the power of forward guidance. Alternative candidates to lead the central bank would inevitably raise questions about policy continuity (as with the current U.S. discussions concerning Chairman Bernanke’s replacement). Championing candidates with a different opinion about the appropriate monetary stance or tactics for current conditions would undermine the credibility of prevailing forward guidance pronouncements.
Has Forward Guidance Worked?
Forward guidance comes in many flavors and central banks continue to revise their recipes to heighten its effectiveness. Constrained by the ZLB, central banks have placed priority on using communications strategies to influence current economic conditions. Since 2008, the major central banks have tried several variations of forward guidance — open-ended statement, time-contingent guidance and state-contingent guidance — in combination with balance sheet strategies, yet global growth remains stalled. Adaptive forward guidance has been difficult to implement and evaluate. Open-ended guidance has had limited or even negligible efficacy while calendar-based guidance has drawbacks because it does not provide information about how a policy would react to inevitable shocks. Even the limited state-contingent guidance implemented by Fed and BoE are incomplete insofar as they do not inform the public about how rates would change once the unemployment rate reaches the designated thresholds.
Ideally, policy makers should fully disclose details of the new policy rule. This way the public can make plans that can anticipate how policy rates would change when the economy is subject to different shocks. More importantly, the public would have evidence that the central bank’s reactions will be different than those taken in the past. This is a key requirement if the new policy rule is to be effective in stimulating growth with rates still at the ZLB. The public has to be convinced that the “punch bowl” will be refilled until everyone stops drinking instead of taking it away before the party is over, if they are expected to reduce precautionary savings and accelerate investment plans.
Although several unconventional monetary tools may lower long-term interest rates, the evidence is mixed about their ability to boost aggregate demand at the ZLB. Empirical studies suggest asset purchases affect both GDP growth and inflation, but there is considerable uncertainty about the size of these effects.1 Obscuring the monetary transmission channels involving long-term interest rates is the changing relationship between bond yields and GDP growth. These historical transmission channels have witnessed considerable innovations in financial technology and practices in recent years that have changed the process of financial intermediation globally. Moreover, the 2008 financial crisis has also impaired some of the main transmission channels, especially those connected to the real estate and mortgage markets.
Most studies assess the success of forward guidance by gauging its ability to lower long-term rates but not its efficacy as an independent monetary tool. As important as lowering long-term rates may be for the transmission of monetary policy, its ability to influence aggregate demand and inflation independent of LSAPs has important implications for capital markets and the economy going forward. Limits to central bank balance sheet expansion mean that LSAPs will need to slow and eventually stop. Concerns about the prolonged use of LSAPs include increasing financial stability risks, incipient inflation concerns, and growing complexities about exit strategies.
Forward Guidance as the Central Bank’s Primary Policy Tool
The Fed has signaled an imminent reduction in the past of asset purchases, and the conclusion of LSAPs altogether by mid-2014. Market participants have interpreted this guidance as a promise of future tightening. Indeed, markets appear to have perceived this policy shift as sufficiently sizable and immediate to cause long-term Treasury and mortgage rates to rise significantly.
To maintain the current easy monetary posture, the July 2013 FOMC minutes indicated that several members were ready to vary the unemployment threshold in the forward guidance. They believed that lowering the threshold could shift the policy mix to provide the desired degree of accommodation, presumably to offset the impact of tapering LSAP purchases. The brunt of adjusting the desired easing increasingly would have to be borne by forward guidance should tapering accelerate to allow the Fed to end its purchases on the originally announced schedule.
This step prematurely elevates the stature of forward guidance to becoming the principle monetary policy instrument while at the ZLB. Indeed, the global experience with state-dependent forward guidance still is measured only in months, and there is little evidence to support such confidence in this policy tool. Operationally, before we treat forward guidance as a substitute for LSAPs, we need to know the answers to the following questions: “How many billions of dollars in tapering will be offset by a percentage point reduction in the unemployment threshold?” and “What would be the equivalent change in the federal funds rate?” Yet, despite considerable theoretical and operational hurdles, forward guidance appears on track to become the primary unconventional monetary policy tool so long as economic growth remains stalled and interest rates continue to be near the ZLB.