Forward guidance has made monetary policy less effective
I am on the record as someone who believes that monetary policy has become almost completely ineffective. One reason for central banks’ inability to stimulate the economy is the zero lower bound on interest rates. As interest rates approach zero, central banks have less room to cut interest rates and even if they do (and engage in non-traditional policy measures like quantitative easing) it makes little to no difference to businesses and households. If you haven’t taken out a loan at 0.5% interest rates, why should you take one out at 0.25% or 0%?
Another reason why I think monetary policy has become ineffective is that central banks have changed their communication style. Forward guidance – originally invented by Mark Carney during his tenure at the Bank of Canada – has been hailed as this wonderful innovation by central banks to anchor inflation and interest rate expectations. Yet, in the real world, forward guidance has been completely ineffective in influencing inflation expectations of most consumers in an economy. As Andy Haldane and Michael McMahon have nicely demonstrated, the problem with central bank communication is that it assumes the public understand what central banks are doing when they change interest rates and that the public actually pays attention to central bank communication. Yet, it is clear that neither private households nor businesses spend much time forming inflation expectations or interest rate forecasts.
But just because forward guidance isn’t effective in the real world, doesn’t mean we should abandon it. After all, in the past, many central banks would not announce interest rate changes in advance at all. Instead, traders would show up in the morning and realise that the Fed charges a different rate today than yesterday. In the 1980s the Fed (and later other central banks) switched to a pre-announcement policy, where the central bank would announce an interest rate change that would come into effect a few days in the future. And after the financial crisis, forward guidance becomes the norm, and central banks committed to a specific path for interest rates many months into the future.
In a series of laboratory experiments, Oleksiy Kryvtsov and Luba Petersen have tested the impact these policies have on inflation expectations and interest rate expectations. They invited undergraduate students to an experiment where they had to form expectations about future rates and inflation. The control group formed expectations based on macroeconomic descriptions of the economy, while the treatment groups had access to additional information from simulated central bank communication. Three central bank communication strategies were tested. First, there was backward-looking communication where central banks announced an interest rate change after it was implemented and explained why this action was necessary. Second, forward-looking communication was tested where central banks announce an interest rate change that would take effect immediately, and the reasons why this rate change was necessary. Finally, a forward guidance strategy was tested, where central banks would commit to a specific interest rate path several periods into the future and why this was necessary.
The chart below shows the difference between control groups (which did not get any central bank communication) and treatment groups for the three communication strategies when forming expectations of future interest rates. The red diamonds in each chart show the statistical significance level of the difference between control and treatment groups. It is easy to see that in the first two cases interest rate expectations react more to central bank communication than in the forward guidance case. In other words, if a central bank engages in forward guidance, nobody seems to care about their announcements (at least not in the general public).
Impact of central bank communication on interest rate expectations
Source: Kryvtsov and Petersen (2020). Note: BACK = central bank announces interest rate changes after implementation, FWD = central bank announces interest rate changes just before implementation, COMMIT = central bank commits to a future path of interest rates (forward guidance).
An even more pronounced picture is visible for inflation expectations. While traditional central bank communication creates a meaningful shift in inflation expectations (and hence in real word actions like the demand for loans and mortgages or changes in consumption) forward guidance does no such thing.
Impact of central bank communication on inflation expectations
Source: Kryvtsov and Petersen (2020). Note: BACK = central bank announces interest rate changes after implementation, FWD = central bank announces interest rate changes just before implementation, COMMIT = central bank commits to a future path of interest rates (forward guidance).
It is bad enough that monetary policy has become less effective due to the low levels of interest rates. Not raising interest rates when central banks had the chance to do so over the last two decades was tantamount to shooting themselves in the foot. By changing their communication strategy and adopting forward guidance, central banks have effectively shot themselves in the other foot as well.