Forward guidance: making it up as you go along

The banking industry likes superfluous language. There's "quantitative finance" for example, which (given that finance isalready a quantitative subject) is a bit like saying "aerial flight" or "wet swimming".

And then there's "forward guidance". What, as opposed to backward guidance? I mean, what other type of guidance is there?

The Bank of England
Alice Tidey | CNBC
The Bank of England

Last summer the Bank of England (BoE) decided it wanted to import the U.S. Federal Reserve's forward guidance policy. In short this went along the lines of "we'll link future moves in the base rate to other external market indicators, so that as these other indicators move then so will base rates. Thus by keeping an eye on these indicators you will know when to expect interest rates to rise".

Simple, eh? The BoE decided to link its base rate expectation to the level of unemployment. At the time, for me it was like watching England play football. You know, the bit in the game when the manager makes some inexplicable substitution and everyone in the stands cries, "what on earth is he doing?!".

That's what I thought of the BoE's forward guidance policy, which stated that when unemployment reached 7 percent, the Bank might think about raising rates. As the Bank's econometric model predicted that this level would not be reached until 2016, one could safely conclude that rates were staying put until then. There were the usual caveats.

What on earth? The level of unemployment is a function of so many varied and diverse causal factors that to suggest that one could safely predict its future level reflects the mind of a charlatan. Many factors drive the employment rate, and some of them (seasonal, sentiment, external like euro zone health, etc etc) have nothing to do with monetary policy and are outside one's control. Why would one link the base rate movement to that? It's completely nonsensical, and I wrote as much on a CNBC blog last year.

Of course the inevitable happened. The unemployment rate fell faster than the Bank expected (in other words, it had underestimated the strength of the U.K.'s economic recovery) and is now below 6.6 percent. So we should raise rates then, right?

Er…no. A few months after it introduced the policy the BoE saw itself at risk of being left with egg on its face and made modifications to its forward guidance (now less transparent to the market than before they had any "guidance" at all). So that fixed that.

And then the U.K. economy continued to go from strength to strength, with the yield curve implying rates would rise in the first of second quarter of 2015. So up pops the BoE governor to suggest that in fact the markets have it wrong, rates could rise this year! Oh, okay then. And then on Tuesday the governor was in front of the parliamentary committee and hinted in fact no, a rise may be later than this year after all.

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I have a suggestion for the BoE. Just say nothing at all about the next move in the base rate. At least you won't give the impression that you're making it up as you go along.

Professor Moorad Choudhry is at the Department of Mathematical Sciences, Brunel University and author of The Principles of Banking (John Wiley & Sons 2012).