By James Saft
Feb 11 Key central banks appear to be down to
their last tool: making promises.
Unfortunately these promises - "forward guidance" in banker
parlance - are ones they appear unable to honor for more than a
few months, and ones that investors demonstrably didn't believe
while they lasted.
Both the Federal Reserve and the Bank of England are likely
to provide updated or clarified forward guidance this week,
painting a new and presumably more believable picture of what
they will do about interest rates under what circumstances.
The BOE should give new information about forward guidance
as part of its Inflation Report to be issued on Wednesday, while
many investors expect Fed chair Janet Yellen to expand on
forward guidance when she testifies before Congress.
With interest rates close to zero, central bankers have
limited levers with which to move the economy one way or
another. Quantitative easing - buying bonds or other assets - is
one option, but there are good reasons to believe that while it
ratchets up values in financial markets, it does so at the risk
of causing dislocations and with uncertain benefit to the actual
That leaves forward guidance, in which central bankers try
to guide expectations about when and why they will change
policy. If it works it can allow central bankers to control
longer-term interest rates despite an inability to cut them
further. It is a bit like a free pass - no cost, easy to retract
and theoretically quite useful.
Useful in theory, but extremely thorny in practice. To work,
two key things have to happen; the central bank has to make good
predications about the future and the market has to believe they
will act as they've indicated they would.
Take the Federal Reserve, which has flagged unemployment
falling to 6.5 percent as part of its forward guidance about
when it may consider raising rates. For reasons of demographics
and a host of other issues, the U.S. unemployment rate has
fallen rapidly - now standing at 6.6 percent - but the rest of
the economy has not followed along.
That puts pressure on the Fed to revise its goalposts, and
in itself, given the central bank's desire to cut back on
quantitative easing, undermines them even as they do.
"The Fed is effectively out of bullets. 'QE-Infinity' was
never possible in practice, though it sounded good in theory,"
London-based hedge fund manager Stephen Jen of SLJ Partners
wrote in a note to clients.
"'Forward guidance', which is a psychological game, is the
Fed's last bullet."
FORECASTS ARE HARD
The Fed adjusted this guidance in December when it began the
taper, and other Fed officials have recently suggested that it
could be supplemented or replaced by a broader array of
employment indicators, or by making reference to the Fed's own
But making predictions, as the old joke goes, is hard,
especially about the future.
Just last August the BOE unveiled a rather complicated set
of forward guidance signposts, including a 7.0 percent
unemployment rate, which it said then wouldn't be hit until late
in 2015. As it happens, British unemployment is now 7.1 percent
just months later and, though the BOE left rates on hold last
week, pressure is on to come up with a framework which better
fits the facts at hand, which is a UK economy recovering
somewhat but far from needing outright monetary tightening.
The BOE's solution may well turn out to be falling back on a
range of forecasts, or potentially a range of forecasts on a
wider range of indicators, but in any event the two central
problems will remain.
It is extremely difficult to predict economic data, and it
is even harder to predict one's own position relative to that
data. That is the problem with all long-term contracts, even
ones with plenty of escape clauses. Both parties to the
contract, in this case the central bank and the markets,
understand that everyone is going to do whatever they think is
in their own best interest once they see how things turn out.
Any other expectation is silly.
This leaves central banks, and investors, in a somewhat
delicate position. It is fine for policy makers to have a
pretend tool, and for investors to pretend to believe it, so
long as events play along.
The big issue won't be if a recovery comes too quickly. In
that case, central banks will tighten and everyone will forget
about forward guidance. The problem comes, instead, if things
Given that central banks seem less willing to buy assets, it
will be much harder to get investors to believe forward guidance
if it is called upon to seriously loosen policy.
Talking has it limits, let us hope we don't reach them.