The Drawbacks of Forward Guidance

BERLIN – The nomination of Janet Yellen to succeed Ben Bernanke as Chair of the US Federal Reserve comes at one of the riskiest moments in the recent history of the Fed. The Fed’s announcement in May that it might start tapering its long-term asset purchases surprised many central bankers, and triggered a sell-off from markets worldwide. But some of the good news about America’s economy was bad news for financial markets, because investors considered the Fed’s potential policy tightening in response to such news to be more relevant than the news itself.

Then, last month, when the Fed postponed its withdrawal from so-called quantitative easing, markets quickly turned euphoric. Indeed, investors today appear less concerned about the real economic story than about the Fed’s interpretation of it. This underscores an important risk that Yellen must now reckon with as she guides US monetary policy: in the longer run, the dominance of the Fed’s views in the market may cause serious economic harm.

The problem for the Fed and other central banks lies not in monetary accommodation, but in their communication strategies. Their extensive promises, assurances, and pre-commitments have lured market participants into a false sense of security. This has induced market players to take on the wrong types of risk, leaving them poorly prepared for adverse changes in the economy and posing a broader threat to long-term financial stability.

Central banking is all about managing market expectations. Monetary authorities have, in recent years, made the way they communicate – about their thinking and possible actions – their primary tool to guide markets and anchor expectations. This is especially true of so-called forward guidance on policy rates – and increasingly so as central bankers’ scope for policy action has become more limited.