Central bank forward guidance; Is it an effective monetary tool?

20 Oct 2022 , 10:44 AM

Forward guidance refers to the practice of central banks giving outlook on how the central bank will handle interest rates and liquidity in the coming months and quarters. Normally, such guidance ranges from short term guidance of 1-2 quarters to long term guidance ranging from 3 years to 5 year.

In the Indian context, the RBI has used the rate action and the rate guidance combined to give a trajectory and to fine tune market expectations. While this has stood the test of time, some of the MPC members like Jayanth Varma have had reservations about such guidance. Varma has been consistently of the view that such guidance tends to tie down the central bank to a certain course of action and takes away their flexibility. Instead, experts like Varma have suggested a data-driven approach where decisions are based on current data.

The truth obviously lies somewhere in between. At a recent presentation organized by the Money Marketeers of New York University; Fed governor Michelle Bowman spoke at length about the role of forward guidance in setting the tone of monetary policy, its rules, applications and exceptions.

Explicit use of forward guidance as monetary tool

By explicit guidance we mean the guidance that is absolutely laid out in very specific terms. There is no scope for interpretation. Between March 2022 and September 2022, the US Federal Reserve hiked the rates by 300 basis points from the range of 0.00-0.25% to 3.00-3.25%. Through this process of increasing the rates, the Fed never left the markets in any degree of doubt. The Fed has hiked rates by 75 bps in the last 3 occasions and will mostly hike rates by another 75 bps in November. The guidance in all the cases was laid out well in advance and the Fed has stuck to that guidance.

According to Bowman, back in the first quarter of 2022, the Fed had underlined its stance that rates would be raised in tandem with the persistence of inflation. As inflation has persisted at above 8%, the Fed has been relentless in raising rates. This is notwithstanding the fact that the rates are already 50-75 bps above the neutral rate and there is a distinct possibility that the rate hikes would start to hit growth and even, perhaps, cause a mild recession in the US economy. The Fed has already guided that it was willing to go all the way to 5.25%, if warranted, by persistent inflation. In short, the future path is quite clear.

Inflation declining versus Inflation starting to decline

There is normally confusion about the tipping point when the Fed would change its stance from hawkish to dovish. Here again, as Bowman puts it, the Fed has given appropriate guidance. For instance, the Fed has drawn a subtle difference between Inflation falling and Inflation starting to fall. To quote Bowman, “If the Fed does not see signs that inflation is moving down, then sizable increases in the target range for the federal funds rate should remain on the table”.

Regarding the tipping point, Bowman has also added that “If inflation starts to decline, then a slower pace of rate increase would be appropriate”. The moral of this guidance is that the federal funds rate may even move up to a restrictive level and stay there for some time. Remember, here the guidance does not talk about the specific number but gives a picture of how the Fed would react to the data points.

Explicit forward guidance as a monetary tool

According to Bowman, explicit forward guidance is not about levels but about clarity to the markets of how the Fed would read data. The uncertainty on the inflation front makes it tough to provide precise guidance on the path for the federal funds rate. That is where explicit forward guidance can come with a “What If” scenario to give clarity. Here is what Bowman has to say about the role and relevance of forward guidance.

a)      According to Bowman, explicit guidance is about specific economic outcomes like 2% inflation, 4.5% unemployment, 3% growth in GDP etc. These will be the basis for forward guidance by the Fed.

b)      Forward guidance need not be explicit about future policy actions or the timing, but it can just describe likely policy actions by the FOMC as a reaction to data flows. Forward guidance here is essentially meant to influence public expectations.

c)      According to Bowman, if inflation has to trend lower in the long term, then the inflation expectations have to come down. That would come down only when people are confident that the central bank is relentless in fighting inflation. Guidance helps here.

d)      According to Bowman, explicit forward guidance is an adjunct tool to the actual policy action. For instance, it is not sufficient just to manage inflation with rates. It has to be burnished with an explicit guidance that can play the role of influencing and fine tuning long term expectations of the market on inflation, interest rates etc.

e)      According to Bowman, explicit forward guidance became more important in the aftermath of the global financial crisis of 2008. Post the GFC, global central banks have perennially used monetary policy to manage the forces of growth and employment. That had made forward guidance a lot more relevant in the post GFC period.

f)       A major concern about forward guidance is the alteration trade-off. Bowman explains this paradox in an interesting way. According to Bowman, if the forward guidance is changed too often, then it betrays a sense of policy ambivalence. On the other hand, if the central bank delays the guidance shift for too long, it may become redundant. Explicit forward guidance has a cost in the form of loss of flexibility, but that is a price worth paying, according to Bowman, as it improves the quality of communication.

Key takeaways for the RBI on explicit forward guidance

Unlike the Federal Reserve, the RBI does not provide explicit forward guidance. However, the RBI has focused a lot on communication with the RBI governor releasing a detailed statement after each policy and also fielding questions from senior bankers and the press. For example, post COVID, the RBI did give explicit guidance that it would keep the stance of the policy accommodative to revive growth, as long as it was required.

However, in the last few months, the markets have been in a state of flux. In May 2022, the RBI made a shift towards rate hikes and withdrawal of accommodation. However, its explicit forward guidance also states that the RBI would not allow the GDP growth to be hampered. Here the RBI guidance is at cross purposes, something that Jayanth Varma has frequently highlighted. Even IMF pointed to this anomaly in the RBI-MPC forward guidance.

What is the way out? One way is for the RBI to rely on statistical outcome targets. Like the Fed, the RBI can also look at explicit targets for growth, inflation, cost of funds and currency, that would signal a shift in the policy stance. Outcomes are much easier to understand than the mindset of the policymakers under abstract conditions. Making this change would, probably, make the forward guidance more valuable in the Indian context.