The idea of a Central Bank offering ‘forward guidance’ as an insight into its thinking on policy areas – particularly interest rates – is a relatively new one for the UK. The practice was introduced here only this summer by the freshly installed Bank of England governor Mark Carney, who had himself used it back in 2009 in his previous role as governor of the Bank of Canada.
Forward guidance was first used at the US Federal Reserve in 2008 and even earlier in Scandinavia – in 2007 by Norway’s Norges Bank and in 2005 by the Riksbank in Sweden. It is thanks to these last two that we have an interesting chart to look at because they both publish data on the directions in which the majority of the banks’ board members expect interest rates to head.
That has enabled some helpful analysts at Goldman Sachs to come up with the graph below and, as you can see, it actually looks like someone has attacked a nest of spiders with a rolling pin. Not only is it a neat illustration of how actual policy rates never end up doing what forward guidance says they will, it is yet another reminder of the folly of trying to forecast, touched on in pieces such as Prophet warning.
As at 11th February 2013.
None of this is to suggest forward guidance is wholly without merit – at the very least, the increased light it sheds on the thought processes of the Bank of England’s monetary policy committee (MPC) does seem a step in the right direction. But the idea of people actually relying on explicit forward guidance is a concern since – as we saw above – that guidance rarely ends up being much of a guide.
If you need further convincing, then look no further than Carney’s letter to George Osborne on 7 August 2013, which informs the Chancellor of the Exchequer the MPS has concluded that “explicit forward guidance can enhance the effectiveness of the [Bank of England’s] exceptionally stimulative monetary stance”.
What is wonderful about the letter is the level of caveat deemed necessary to accompany the forward guidance. Thus, while the thrust of the letter is interest rates will be kept low and asset purchases will be maintained until unemployment falls to 7%, Carney adds: “The guidance will cease to apply if material risks to price stability or financial stability are judged to have arisen.”
That catch-all caveat pretty much translates as ‘if anything changes, we reserve the right to change our minds’ and then there is the sentence: “In essence, the MPC intends at a minimum to maintain the current exceptionally accommodative stance of monetary policy until economic slack has been substantially reduced, provided that this does not put at risk either price stability or financial stability.”
Let’s set aside for a moment whether a universally accepted unit of measurement for changes in the level of “economic slack” actually exists and go along with the Bank of England’s yardstick of the UK’s unemployment rate. In the minutes of the MPC’s October meeting, it was noted that the headline unemployment rate has fallen to 7.7% but remained well above the 7% forward guidance threshold.
The minutes continued: “The recent reduction in the unemployment rate indicated that slack in the economy was, as anticipated, being eroded as activity picked up. If anything, that was occurring a little faster than envisaged at the time of the August inflation report although it remained unusually difficult to gauge the effective degree of slack in the economy.”
Yes, those are our italics but the fact the MPC is currently basing its forward guidance on something it is not quite sure how to measure seemed to warrant them. It is of course not the place of The Value Perspective to dictate how Central Banks go about shaping and issuing their forward guidance but we do feel able to suggest market participants look beyond any attempt at forecasting and instead focus their attention on aspects of investing that have proved rather more reliable in the longer run.