Perils Of Forward Guidance

07 August 2013 9:47:00 AM


Markets like certainty to be able to plan ahead. For businesses, it is a similar story, a clear picture of what interest rates may do in the future is valuable information to have when taking out a loan to cover business expansion, for instance, so there are good reasons why a central bank might wish to share its longer range opinions with the public.

The Bank of England is planning to offer Forward Guidance with respect to its interest rate policy. In fairness, anybody who has an interest in economics knows that the Bank of England, ECB, Bank of Japan and the Federal Reserve are likely to keep interest rates on hold for quite some time to come, or perhaps ease them slightly where scope remains (ECB). However, official clarification could provide a welcoming reassurance.

A leading academic who has written extensively on the practice has said that the policy might have undesired consequences. In an interview with the BBC, Professor Michael Woodford of the University of Columbia warned: “If it's too successful, maybe it then pushes up inflation more than you want, and that's obviously a concern in the UK as the Bank of England has been overshooting its inflation target as it is. But the view of undertaking such a policy is that you are concerned enough about undershooting in terms of the real economy that you do in fact want more stimulus, even if it nudges up inflation a little bit as the price of getting it. The ideal thing would be to talk about specific economic conditions and say interest rates will stay where they are until certain conditions that are not currently satisfied are reached. And to define those conditions in such a way that if inflation did start shooting up faster than you expected, then that would bring the date forward."

In his opinion, giving a specific date for rates to remain on hold is risky: the Bank of Canada did this in 2009 under its Chairman, Mark Carney, the recently installed Governor of the Bank of England. The Federal Reserve and the ECB have both adopted forward guidance and the Bank of England is set to announce the policy later this month. However, Woodford notes that: “I would encourage them that they should be trying to use it. It's certainly easy to get it wrong, but I wouldn't take the view that it's easier to keep your mouth shut.”

Dr. Mike Campbell is a British scientist and freelance writer. Mike got his doctorate in Ghent, Belgium and has worked in Belgium, France, Monaco and Austria since leaving the UK. As a writer, he specialises in business, science, medicine and environmental subjects.

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