Forward guidance is unravelling for the major central banks in different ways. The approach of a single target (inflation) with a single tool (interest rates) is long gone. Instead, we are left with an array of targets, goals, thresholds, commitments and caveats, which is proving too much for central banks to successfully manage. Furthermore, no target is perfect and trying to achieve it can create more problems than it solves.
The US was the first, introducing forward guidance early on in the financial crisis (time specific) and then backing it with an unemployment rate threshold at the end of last year. Yes, it most likely helped ensure short-term interest rates were lower than would have otherwise been the case and there remains the debate as to the impact of these low rates on asset markets, combined with a period of low business investment. There is growing talk that the Fed might have to move down its 6.5% threshold for unemployment, because low and falling labour force participation has been a factor in pushing it lower. Simple calculations suggest that the rate could now be in double figures if participation had remained at the pre-crisis average. Instead, many workers have simply left the labour force, rather than actively looking for work. So the move towards the 6.5% level reflects, in part, the fact that participation is at a level last seen in the late 70s and that’s a structural issue that cannot be addressed by the Fed and certainly should not (all else equal) lead to tighter monetary policy.
For the UK, it’s the data that has largely undermined the Bank of England’s forward guidance, formally launched in August, with lots of caveats. This year, the Bank has moved from constantly revising down growth forecasts on a quarterly basis to revising them up. But again, the unemployment rate ‘intermediate threshold’ has its own issues, in the form of low productivity and stagnant real wage growth. So again, a move towards the chosen threshold (7% rate) may end up reflecting deeper-rooted structural issues which monetary policy cannot address.
As for the ECB, there is a slightly different problem. Guidance was the weakest form, so promising to keep rates low “for an extended period”, but the fact that the pressure is now the other way (for lower rates and/or more liquidity) reflects the fact that the policy was introduced when the pressure for Fed tapering was feeding through into Eurozone interest rate markets, rather than domestically generated pressures.
For all, fighting against market pressure for higher rates merely pushes the eventual adjustment into the future. This may be the aim, but it also creates the risk that market re-pricing will be sharp, rather than gradual. For FX, the overall price action on EURGBP has reflected the fact that the market has placed more faith in the ECB than the BoE, something which could push the cross to early January levels (below the 0.83340 early October low) should the ECB shift policy before year-end (see “ECB rate cut the worst available option” for more).