Why Central Banks Must ‘Promise to Be Irresponsible’
The European Central Bank (ECB) and the Bank of England (BoE) last week introduced "forward guidance" as the new tool of monetary policy. The move was a big change, particularly for the ECB, and the forex market reacted accordingly. I think it was just the first in what's likely to be a series of steps from these central banks in the same direction. That suggests that both the euro and sterling are likely to decline further down the road.
Forward guidance means giving the markets clear guidance about what the central bank intends interest rates to be in the future. Such guidance is crucial, because investors form their intentions not only by the current level of interest rates but even more by what they perceive the future path of interest rates is likely to be. By shaping investors' views of the future path of rates, central banks can influence their views on the likely path of the economy, inflation, and financial markets. It reduces the uncertainty surrounding the future, which should increase risk-taking.
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The simplest way of giving forward guidance is to give a rough idea of how long interest rates are likely to remain low. That's what ECB President Mario Draghi did. He said that "the Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time." That might not seem like much – indeed, it might seem like exactly what everyone in the markets was already expecting, given the weakness in the euro zone economy - but for institutions whose mantra up to now has been that it "never pre-commits," it's a big deal.
The more complicated way of giving forward guidance is to set out in advance what the conditions would have to be for the central bank to change policy. This is called conditional forward guidance. For example, the Bank of Canada under Mark Carney – who is now the governor of the Bank of England - said in 2009 that its commitment to keep rates low was based on interest rates and inflation rates. These are the usual kinds of targets for a central bank.
This year the U.S. Federal Reserve said it would maintain the current stance of monetary policy so long as inflation remains below the target of 2 percent and the unemployment rate remains above 6.5 percent. Adding the unemployment target was a real change for central banks; it tied monetary policy to the performance of the real economy, which is not the usual way central banks operate.
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Now, how successful is forward guidance? The academic research suggests its record is mixed. Forward guidance that simply forecasts future macroeconomic performance and the monetary policy actions that the central bank is likely to take in response apparently doesn't accomplish much.
Some academics call that "Delphic" guidance, after the ambiguous forecasts that the oracle at Delphi made. That's the kind of "guidance" that Draghi gave. Even if he did strongly hint that rates will remain at or below current levels for a year, there's nothing to stop the ECB from changing its mind and tightening six months from now if the situation changes.
Draghi tried to counter that impression by stressing that the decision was unanimous, meaning that even the Bundesbank hawks on the Council, who might in the future press for an early change, signed off on it. Yet the ECB's strong anti-inflation credibility and its unambiguous single mandate work against it in this instance. That may be why although the currency market reacted strongly to Draghi's statement, the interest rate futures market didn't, and the expected course of short-term euro rates was not much changed from a week earlier.
Forward guidance is more successful when the "guidance" is actually a "commitment" to act differently in the future than it normally would because of what has happened in the past. Central bankers need to convince the market that contrary to their usual behavior, they won't take the punch bowl away just as the party gets started. Investors can then anticipate a time when monetary policy will be inappropriately loose, bringing a period of above-trend growth, and gain the confidence to invest and spend now.
That's why Nobel prize-winning economist Paul Krugman has argued that "the central bank needs to credibly promise to be irresponsible." Academics call this "Odyssean" guidance, referring to the way Odysseus lashed himself to his ship's mast so that he was committed to hearing the Siren's songs. By restricting now during the slump what they will do when the good times return, central banks become more believable and can have a more powerful effect on the markets.
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There are two points in this analysis that are significant for the forex market. The first is, the statements by the Bank of England and ECB had a huge impact on the market. They sent both the sterling and the euro sharply lower. The second point is, both of these statements are still in the realm of "Delphic" forward guidance, not "Odyssean."
For example, all the Bank of England said was that "in the Committee's view, the implied rise in the expected future path of bank rate was not warranted by the recent developments in the domestic economy." In other words, it said it thought the market's forecasts were wrong, but it didn't even say what the correct forecast would be, much less make any commitment to achieve that forecast.
The Committee strongly suggested though that it would give more detailed forward guidance at its next meeting in August. While the Bank of England's statement moved the forex market, it had even less effect on short-term rates than the ECB's statement did.
Moving the forex market is not enough for these central banks. They need to convince the rates market as well in order for their monetary policy to permeate the real economy. I think both will have to move sooner or later from the weak "Delphic" type of forward guidance, in which they describe the future course of monetary policy that they would like the markets to anticipate, to the "Odyssean" approach in which they commit to changing the way that they respond to changes in the economy.
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They will have to "credibly promise to be irresponsible" so that their statements affect the interest rate market as well as the forex market. That should give the pound and the euro another leg down, in my view. This change will probably be easier for the Bank of England than the ECB, which means a greater decline in the pound than the euro. In other words, I think their recent statements were just the first step in these central banks' adoption of forward guidance and therefore just the first step down for their currencies.
The author is the head of global FX strategy at IronFX, an online trading firm specializing in forex, CFDs on U.S. and U.K. stocks, and commodities. He was previously head of the forex committee at Deutsche Bank Private Wealth Management.