The writer is chief European macro strategist for T Rowe Price and a professor at King’s College Business School
Central bankers fell in love with forward guidance over the past decade. By hinting at the future path of interest rates, they hoped to steer the entire yield curve with a few well-chosen sentences.
But new Federal Reserve chair Kevin Warsh has sharply broken with this tradition. No more promises or dot plots. The markets have to figure it out themselves. And bond yields have shown strong reactions to his first two press conferences.
Extrapolating from this sample of two, many market observers predict more bond market volatility as a result of this change in communication. At first, that seems like an intuitive conclusion. But does forward guidance really limit the effect of Fed communications on financial markets?
Central banks have been on an odyssey with forward guidance. Pronouncements about the future inevitably involve some credibility risks, and as arch-conservative institutions, many central banks therefore avoided forward guidance to begin with.
Instead, they abstained from future rate statements and let financial markets react to the data. Former Bank of England governor Mervyn King referred to this idea as the “Maradona theory” of interest rates — feinting in one direction, then the other, but in the end delivering the final policy without moving much.
But that changed with the Federal Reserve, which opened Pandora’s box of forward guidance, using such signalling more than any other major central bank.
Forward guidance comes in different flavours. The majority of guidance is “Delphic”, or state-dependent, in nature. Like the Oracle of Delphi, all-knowing central banks, employing an army of economists behind them, provide rate guidance conditional on a future event.
A typical example of Delphic guidance is a statement that rates will remain low as long as inflation stays below 2 per cent in the future. But of course Greek mythology offers several examples where Delphic forward guidance can seriously backfire.
Much like King Croesus, who fatalistically misinterpreted the Oracle of Delphi’s prophecy of his own downfall, the Bank of England suffered from its own communication failure in 2013. Markets inferred that only the unemployment rate threshold mattered for keeping the bank rate at a low level. Yet that threshold was met within six months of the announcement, leading to a loss of credibility for the BoE and a revision of the policy.
In another Greek myth, after learning that he will kill his father and marry his mother, Oedipus tries to avoid his fate, but in doing so actually fulfils it. Likewise, in response to policy promises conditioned on a weak economy, households and firms might cut back consumption and investment. The prediction itself can become self-fulfilling.
Occasionally, central banks have relied on Odyssean forward guidance: a promise to keep interest rates at their current level, regardless of what comes next. By tying its hands to the mast, like Odysseus, the central bank promises to resist the future temptation to raise rates.
To assess whether forward guidance genuinely sharpens central bank communication, we need only look at how markets react in real time. Examining 30-minute yield swings after Fed announcements reveals how investors digest conditional (Delphic) forecasts versus hard (Odyssean) policy commitments — and whether hawkish or dovish signals actually land as intended.
Outside periods during which interest rates were at or near 0 per cent, market reactions were broadly similar whether the Fed provided guidance or not. While guidance during zero-lower-bound periods led to more muted responses, it remains unclear whether that reflected the guidance itself or simply the lack of room to move policy rates.
The Bank of England has always favoured Mervyn King’s “Maradona theory”. However, apart from a brief spell between 2014 and the start of 2017 under Mark Carney when forward guidance kept interest-rate volatility at bay, market reactions to policy announcements have been roughly the same, with or without guidance.
The European Central Bank provides perhaps the most interesting case study. While Mario Draghi introduced forward guidance early in his tenure, from mid-2014, bond-market reactions were at their quietest during the presidency of Jean-Claude Trichet, who eschewed the policy altogether.
Christine Lagarde’s communication during episodes of forward guidance led to some of the largest bond-market reactions in the euro area’s history. Clearly, that was also during a period of large macroeconomic shocks. Even so, the contrast is striking: the quietest meetings cluster under Trichet, while some of the biggest moves arrive in Lagarde-era guidance episodes.
But such a big difference between monetary policy communication with and without forward guidance cannot be observed in the case of other central banks. That suggests that, for the ECB, forward guidance was a Trojan horse: nice to admire, but far from the gift of the gods it appeared to be.
Across the Fed, the BoE and the ECB, yield moves on policy days look surprisingly similar with and without forward guidance. Where guidance did seem to matter, at the zero lower bound and in parts of the ECB’s history, it often coincided with other extreme shocks. Support for the neat textbook story that “guidance tames markets” is hard to find.
What does all of this mean for the Fed’s Kevin Warsh? Should investors expect a lot more volatility out of his press conferences now that forward guidance has been shelved?
The evidence from the Fed, BoE and ECB suggests that formal forward guidance is not, by itself, a reliable way of making policy announcements less market-moving. Market volatility mainly reflects the size of the shocks and the credibility of the person at the podium. Whether Warsh delivers large bond-market surprises will depend less on guidance frameworks and more on the stories he chooses to tell.