Shock and Awe vs. Forward Guidance...

 

https://www.sagia.gov.sa/Global/top_banner/1/monetaypolicy.jpgThe role of forward guidance in steering monetary policy and subsequently consumer/business expectations had emerged to be of primary importance as the FED struggled to cope with economic downturn witnessed at the aftermath of the financial crisis. With interest rates hovering about the zero lower bound this was the only channel of formulating short term rate expectations and by iteration long term rate trajectory.

However with the US continuing to move on a sustainable growth trajectory amidst global imbalances, the role of forward guidance in moving the economy from artificially low interest rates might be nearing its end. The debate of conducting monetary policy via commitment as opposed to ‘time inconsistency’ is an age old one with commitment winning by delivering the same output growth as compared to time inconsistent policy however with lower inflation. Forward guidance can be viewed as an offspring of the policy of commitment.

While economists have always advocated the policy of commitment, the relevance and effectiveness is challenged by the present global economic scenario. With impeccable technological progress ushering in an era of ‘productive disinflation’ (like development in horizontal fracking technology leading to lower oil prices). Price dampening of this kind can coexist peacefully with stagnating wages while simultaneously improving consumer welfare and perhaps lowering long term inflation expectations.

With the rest of the advanced world still dabbling with quantitative easing perhaps the shock and awe impact of a black swan event will prove most effective in normalizing monetary policy.  As we witnessed in January with the Swiss National Bank decision of moving away from the pegging the Swiss Franc to the Euro prior to the much anticipated enactment of QE in the Euro.

Japan was the first country to experiment with unconventional monetary policy and currently spending $700 Billion every month on bond purchases is still far from hitting the magic 2% inflation rate. Central banks across the world such as the Bank of New Zealand has begun to deviate from the policy of forward guidance with surprise cuts on forecasts on the 90 day bank bills. A point where shock and awe trumps over forward guidance is the fact that despite employing sophisticated forecasting techniques, long run forecasts are often not very informative. Thus guiding long run expectations through the tool of short term rates may prove detrimental for expectations and policy.

Janet Yellen in her address at the conference “The New Normal Monetary Policy"  gave mixed signals while pointing out a higher probability of the imminent rate hike in the near future while simultaneously indicating that rate hike will be a function of the pace of recovery. Despite the lower growth rate of 2.2% last quarter as opposed to a 5% GDP expansion in the prior period, the US embraces stronger economic conditions. Perhaps the FED chair is preparing the ground to shock and awe the world audience!

So what are your thoughts on conducting monetary policy?

The content for the blog has been sourced using:

The One Thing You Need to Know About Inflation , Is It Time to Rethink Forward Guidance? , The Fed: We Aren't Using Forward Guidance Any More, But, By-The-Way, We Expect Interest Rates Will Only Rise Gradually, Learning to See Data

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