Could Central Bank Forward Guidance Guide Markets in the Wrong Direction?

by on March 9, 2014 5:00 pm BST

One of the “many tools” central banks have added to their arsenals is forward guidance in order to calm market participants while giving some insight in the future economic outlook. Unfortunately, the Bank of International Settlements (BIS) believe this new tool will create financial instability by repeatedly revising the guidance and keeping borrowing costs too low for too long (Ah, hem Federal Reserve and BoE).

There is little evidence to gauge the true effectiveness of current monetary policies, according a review by Andrew Filardo and Boris Hofmann published in the BIS Quarterly Review.  Filardo, head of monetary policy at the BIS, and Hofmann, senior economist, said “if financial markets become narrowly focused on certain aspects of a central bank’s forward guidance, a broader interpretation or re-calibration of the guidance could lead to disruptive market reactions.”

“Recent forward guidance by four major central banks has so far reduced the volatility of near-term expectations about the future path of policy interest rates. Beyond the impact on near-term policy rate volatility, the evidence is more mixed,” the report said. The Bank of Japan (BoJ) has linked their asset purchase program to an inflation target of two percent. The European Central Bank (ECB) is aiming to keep rates accommodatingly low for an extended period of time.

The Bank of England (BoE) and the Federal Reserve have pledged to increase interest rates once unemployment targets are reached, according to their forward guidance. However, when asked, both central banks have mentioned that the target achievement does not indicate an instant rate hike.

Forward guidance is rendered useless if central banks fail to follow their own outline and credibility could be further weakened.