The ECB Should Resist the Forward Guidance Temptation
Summary. The ECB has all but pre-committed to a June interest rate cut. This is in contrast to its data dependent strategy and the – eminently sensible – communications framework it has built around it. The ECB should remain faithful to the framework, rather than yielding to the temptation to provide forward guidance – for the long-term benefit of both financial markets and the bank’s credibility.
The pandemic ushered in a new macroeconomic regime for the global economy, with an inflation revival being perhaps its most salient feature.
At the ECB, interlocking forward guidance on interest rates and asset purchases, intended to forestall a premature exit from expansionary monetary policy under the previous, low-inflation regime, ended up delaying the necessary normalization of the policy stance. The ECB (like the Fed) fell into the “forward guidance trap” because the policy prescriptions embedded in their forward guidance were – by design – insufficiently contingent on the evolution of the economy.
Thus, when the ECB commenced its policy tightening campaign, the governing council underscored the departure from forward guidance by emphasizing a “meeting-by-meeting” and “data-dependent” approach.
It was the end of an era – I think rightly so. Not just because in a narrow sense forward guidance was responsible for the ECB “missing the exit”. And that forward guidance was unlikely to survive a change of macroeconomic regime – a manifestation of the time inconsistency problem – is also not that surprising.
More fundamentally, forward guidance is not fit for purpose in the new environment.
First, interest rates have – at least for now – risen decidedly away from the lower bound for interest rates, relieving the central bank of the need to communicate longer term plans on its interest rate as a means of affecting financial conditions.
Second, the structural economic changes that came with the new regime have brought on “radical uncertainty”: about the nature and persistence of inflation pressures, the potency of monetary policy transmission, and especially about the level of the neutral rate of interest. A variable that is difficult to pinpoint at the best of times, as it is subject to large model and statistical uncertainty, the neutral rate is now questionable as both a guide for real-time monetary policy and as an anchor for the bond market.
In such an environment, forward guidance is more likely to prove harmful than useful.
The ECB governing council has proceeded to flesh out its data dependent approach by elaborating the variables that enter its reaction function. In addition to a forward-looking assessment of the inflation outlook – essential for any central bank with an inflation target – the reaction function also contains realized underlying inflation and the transmission of monetary policy impulses to the real economy.
Realized underlying inflation reduces the importance of forecasts in the reaction function, making decisions more robust to one-sided forecast errors which had resulted in too slow a response to rising inflation. (The governing council can always dial back the weight of the inertial part to reduce the risk of cutting too late – and communicate accordingly.)
The inclusion of transmission is a recognition that in the euro area’s multi-country currency union, dislocations in sovereign bond markets may affect the monetary policy stance.
While with this reaction function the governing council of the ECB has arrived at a sound framework, in practice its jettisoning of forward guidance has not been consistent. For example,
it twice (June 2022 and February 2023) stated an “intention” to increase interest rates by certain increments in the subsequent meeting. In the former case, the governing council ended up contradicting its own guidance and increased interest rates by more.
in January 2024, President Lagarde appeared to endorse “by the summer” as a “likely” date for the first reduction in interest rates. In the meetings of March and April 2024, the governing council focused investors’ minds on a June cut.
We appreciate that there were nuances and qualifications to such communication.
Yet policy makers should be cognizant that the perception of financial markets has been conditioned, like Pavlov’s dog, by many years of central bank forward guidance. Or, as Jeremy Stein put it: “There is always a temptation for the central bank to speak in a whisper, because anything that gets said reverberates so loudly in markets. But the softer it talks, the more the market leans in to hear better and, thus, the more the whisper gets amplified.”
In any case, these episodes do show a tendency to revert to forward guidance-like communication. What explains this forward guidance temptation?
One reason could be internal disagreement on the best course of action. It may be that providing a firm, guidance-like indication for the outcome of a particular meeting is a compromise between those who want to do more, and those who want to do less.
Another motivation could be “gradualism”, attempting to avoid major surprises for investors by occasionally “nudging” them in the right direction. Indeed, a concern among policy makers seems to be that the data dependent framework “… may lead to excessive volatility as markets overreact to individual data prints”.
Whatever the reason, I think that for the sake of both the credibility of the ECB’s communication and long term financial stability, the governing council should not yield to the forward guidance temptation.
Given the clarity of the reaction function it has outlined, forward guidance is not necessary. The individual variables of the reaction function are observable, and the central bank does not enjoy any particular advantage over the private sector in forecasting them.
It is also not the central bank’s job to attempt to lower market participants’ exposure to aggregate macroeconomic risk (the risk that stems from uncertainty about economic outcomes).
Nor would such an approach likely achieve a sustained reduction in market volatility. Systematic attempts by the central bank to avoid bond market volatility are likely to prove ineffective and socially suboptimal. Trying to be predictable and gradual may encourage leverage and risk-taking, ultimately not doing market participants any favours either. Indeed, recent experience suggests that the risk of abrupt market moves – and the danger of loss of credibility for central bank communication – is greater if markets follow the central bank’s forward guidance, only for the central scenario on the economy to shift.
Forward guidance has overstayed its welcome. It is time the ECB and financial markets emancipate themselves from one another.