Forward Guidance: BIS Warning

In an article in the 3/9 Quarterly Review of the Bank for International Settlements, Andrew Filardo and Boris Hofmann review the implementation, effectiveness, and risks of the NZIRP (near zero interest rate policy) forward guidance of the four major central banks: the Fed, the BOJ, the ECB, and the BOE. They write that while “forward guidance has been helpful in clarifying policy intentions in highly unusual economic circumstances …. the mixed evidence concerning the effectiveness of these practices, and the challenges they raise, caution against drawing firm conclusions about their ultimate value.”

The BIS economists stress that the effectiveness of forward guidance depends on the credibility of the central bank’s commitment to it and to clear communication of the policy. They warn:

However, if too complex, conditionality may end up confusing the public and leading to conflicting interpretations of policy intentions, with the risk of disruptive market reactions. Central banks then face the risk of getting involved in continuous discussions with the media and other observers about nuanced wording and technical details.

This is a significant risk faced by the FOMC in amending its guidance.

A related risk is “committee cacophony in external communication can further undermine the clarity and credibility of forward guidance.” That’s been an ongoing problem with all the divergent views expressed in the all-too-frequent speeches by the members of the "Federal Open Mouth Committee."

Of course, one of the biggest risks of NZIRP forward guidance is that this policy is prone to inflate speculative bubbles:

[P]erhaps more importantly, forward guidance can indirectly create financial stability risks if monetary policy becomes increasingly concerned about adverse financial market reactions (also referred to as the risk of financial dominance). At the current juncture, this could translate into an undue delay in the speed of monetary policy normalisation and raise the risk of an unhealthy accumulation of financial imbalances. Moreover, the mere perception of this possibility, over time, could encourage excessive risk-taking and thereby foster a build-up of financial vulnerabilities.

There are already plenty of signs that this is starting to happen. If the bubbles get bigger and burst, the central bankers will have no excuses given the timely forward guidance provided by this excellent warning from the BIS.