Q&A: What is 'forward guidance'?

Mark Carney Mr Carney said that his forward guidance policy was "working"

The governor of the Bank of England, Mark Carney, has overhauled his policy of "forward guidance", just six months after it was first implemented.

"Forward guidance" is a tool that Mr Carney has shown a penchant for in his previous job heading Canada's central bank, and that he more-or-less put into immediate action in a statement following the first policy meeting under his stewardship.

Mr Carney, and the Bank's Monetary Policy Committee (MPC), delivered explicit guidance regarding the future conduct of monetary policy in August.

But now he has adapted the plan, owing to falling unemployment and an economic recovery in the UK.

What is forward guidance?

It is making a promise about the future, particularly about future interest rates.

The Bank of England, like other central banks, directly controls the short-term interest rate at which it lends to or borrows from the High Street banks overnight.

This is the interest rate that gets set at each of the Bank of England's monthly Monetary Policy Committee meetings.

What's the point of forward guidance?

The Bank can only directly control the short-term interest rate. But this rate has already been cut to the lowest level that the Bank feels comfortable with.

Given that it has exhausted the more traditional option of short-term interest rate cuts, another way for the Bank to support the economy has been to offer this indicator, by which companies and mortgage borrowers can estimate for how long such low interest rates may be around for in terms of months or years.

Forward guidance is thus a way of converting low short-term interest rates into lower long-term interest rates.

The thinking is that if the High Street banks can be convinced that they will be able to borrow overnight from the Bank of England at just 0.5% for many nights - indeed many months or years - to come, then they will hopefully be willing to lend money out to the rest of us for the longer term at a commensurately lower interest rate as well.

Isn't that what Quantitative Easing is supposed to be for?

QE also seeks to reduce longer-term borrowing costs, but in a different way.

QE involves the Bank buying up debts (specifically, UK government debt in the form of gilts) from the market, in return for newly created money in the form of a deposit at the Bank.

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.

Or, to put it another way, by reducing the supply of long-term debt in the financial system, the Bank hopes to drive up the value of the remaining long-term debts, which is mechanically the same thing as driving down the "yield" or interest rate on such long-term debts.

Then why not just rely on QE?

There is no either/or here. The Bank of England can restart its QE purchases if it wants, while also providing forward guidance about its interest rate and QE plans.

However, recent market jitters over plans by the Federal Reserve (the Bank's US counterpart) to "taper" or slow down the rate of its own QE purchases has highlighted two problems with QE:

  • Firstly, it has played on fears, expressed by many bankers, that QE merely inflates bubbles in the prices of other investments, such as risky loans and share prices, which will then burst as soon as the QE stimulus is withdrawn
  • Secondly, the surprisingly strong reaction of markets to the change in tone from the Federal Reserve highlights how important market expectations- as opposed to the mechanics of supply and demand - are for the effectiveness of QE

How did the original version of forward guidance look?

In August, the Bank told the market that it intended to keep the Bank rate at its current historically low 0.5%, at least until the unemployment rate fell to 7% or below.

Mr Carney did not say that interest rates will automatically rise when that threshold is reached, rather that it is a "way station" for further consideration of the issue.

The Bank also added some conditions that would "knock out" forward guidance. These included any sign of runaway inflation, or threats to financial stability.

So what has happened since the summer?

In Mr Carney's own words: "The unemployment rate has fallen much faster than anticipated... and is likely to reach 7% by the spring."

This jobs growth has meant that the Bank has had to take a fresh look at its forward guidance policy.

As a result Mr Carney said that, instead of just the unemployment rate, the next phase of the Bank's interest rate policy would be determined by a range of different indicators. These included aspects such as the output gap - the gap between potential and actual output - and broad terms such as income and spending.

All this has made the policy somewhat more confusing.

However, Mr Carney argues that the change in policy has come because forward guidance is working and has helped to secure growth.

Any other chances of any other changes?

Whatever the Bank promises, it will always have the right to change its mind later. Indeed, Mr Carney did exactly this in his time at the Canadian central bank, breaking an earlier promise not to raise interest rates for at least a year.

This inability to tie its own hands presents the Bank with a conundrum - how to convince markets today to believe promises that in the future it may be strongly tempted to renege upon.

The economist Paul Krugman has dubbed it "credibly promising to be irresponsible", while other financial bloggers have likened the problem to "Jedi mind tricks".

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