Why do we need Forward Guidance?
Interest rates amongst G8 nations have been at historical low levels. Central Banks can directly control short term interest rates but as these rates are already at very low levels cutting the rates of the overnight lending programs is no longer an option if the policy is one to stimulate economic growth.
Forward Guidance is used to target the levels of longer term rates.
The idea is that both the business community and the retail mortgage holder would be able to take advantage of lower long term rates and in the process be encourage to spend and invest thus in the process stimulating economic growth. With interest short term rates being so low why should the Central Banks bother with Forward Guidance. The problem is that with the amount of economic uncertainty out there Forward Guidance allows one to that is more macro and focused on investment because the relevant monetary policy maker has made a promise not to change rules unless the environment changes.
In turn if the retail banks can be assured that short term rates will stay at low levels then they will be encourage to lend the longer term rates or as banker call the long end at comparatively good terms.
But we already have QE?
Quantitative Easing also has a focus on reducing longer-term borrowing rates. However the means of tackling this uses different tools.
QE is all about printing loads of new money and using this new liquidity to purchase debt and in particular government debt. In return the banks pump with liquidity that is deposited in the Banks.
By reducing the available supply of long-term debts for them to invest their money in, the hope is that this will make banks and other financial institutions diversify into other long-term investments - including new loans to the rest of us.
By targeting long term debt the Central Banks in effect reduce the supply of long dated instruments which has the effect of reducing the supply of such instruments. This in turn drives up the value of these long term instruments and pushing down their yield. The math behind it is fairly simple being that lower yield equates to a declining yield curve.
Does QE not work QE?
It is not a simple case of switching to Forward Guidance but more of a case of using both when and where it is appropriate.
The problem has been that the market is schizophrenic mode with one day being full of enthusiasm and other days acting like a manic depressive. This has been highlighted by the recent statements by the Federal Reserve on whether to slow down the rate of its own QE purchases. The question to taper or not to taper has highlighted two problems with QE:
- There are concerned amongst senior bankers that QE just creates new bubbles like the mortgage problems that where experience in the last decade. Furthermore there is a fear that prices are being inflated on high risk loans and the equity markets. Of course these bubbles burst and the mind actually boggles after the efforts of the past five years what creative solutions the great and good will come up with.
- The market is all about future expectations. It has been picked up that the markets are reacting with great volatility on how a change of tone from the likes of Bernanke or how certain individuals vote on the Central Bank committees. One can look back to the time when little Cyprus announce that it was planning to sell it Gold reserves to raise funds happened during the time in the great collapse of this precious metal. The difference between QE and Forward Guidance is that the former is a mechanical means of moving the marketing and the latter uses the powerful tool of managing expectations.
How are the conditions to set?
This is really down to which areas the authorities see as priority. There may be a pledge to keep interest rates at a certain level as long as the unemployment rate is above a certain percentage.
That the Central Bank has made the promise is important in itself as it sets the market environment and mood.
This all sounds too easy. The Central Bank has made a promise will it keep it. Or more importantly does the market believe they can keep the promise? If the markets are not convinced then of course they are probably unlikely to lend longer term at these reduced rates.
So the market expects will Central Bank give guarantees?
Central Banks are not tied to stick to their promise and have the legal right to change their guidance. This actually when the now Bank of England Governor Mr. Mark Carney during his stint as the head of the Canadian Central Bank broke his pledge not to raise interest rates. So why make the promise if you are not going to stick to it? Good question. I am still waiting for an answer.
Shall we just ignore the promise?
A little five letter word”taper” really moved the market recently. It is incredible how the tone or a little word could move the market.
Bernanke simply said that a time table was suggested for a forward guidance policy on QE. However with the market being jittery it decided that what the Federal Chairman was saying that the long end will be steepened and priced in higher longer term rates accordingly.
Bernanke’s guidance is a marked guidance from Alan Greenspan who had the knack moving his lips but saying nothing.
Can Central Banks get the tone just right?
It is a hard one with market participants taking away different meanings from the same statement and this is very apparent during times of high market volatility.
It also depends on the relationship the Central Banks have with the Government as markets in general feel that Central Banks have a liking for tight money whereas the Governments prefer easy money.
Therefore if the Government through its actions and statements is in step with the Central Bank the markets are more likely to believe it.
Then again there is the Euro Zone and in this case I am not sure what to believe.