Still room for improvement with the BoE’s forward guidance, says IMF

July 28, 2014

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There was plenty of support for the Bank of England’s stance on interest rates from the International Monetary Fund in its latest report on the British economy.

But it seemed a little less sure on how forward guidance – the Bank’s cornerstone policy since Governor Mark Carney took charge last year – has fared so far.

While it still backed forward guidance as a step towards greater transparency, the IMF’s report posed two questions: How effective has forward guidance been, and what improvements could be made?

On the first, the IMF noted that members of the BoE’s Monetary Policy Committee said forward guidance was meant to improve transparency about the Bank’s reaction function.

But on that front the IMF wasn’t convinced it had much of an effect on markets:

With regard to its effectiveness in terms of transparency, data on implied volatilities indicate that uncertainty about future rates did indeed fall after introduction of forward guidance. But this evidence is not clear cut—implied vols of many asset classes have been falling steadily since the implementation of unconventional monetary policies.

Viewed this way, it might be that the observed decline in volatility was a reversion to trend, after an exceptional period from the (U.S. Fed’s) first “taper talk” in May to the “no taper” announcement in September, that should not necessarily be attributed to the introduction of forward guidance.

Indeed, volatility across markets continued to decline to the point that the BoE became worried that they were no longer reacting enough to strong UK economic data, and therefore weren’t properly reflecting the range of possibilities for interest rates in future.

That resulted in Carney giving markets a sharp shove last month, as he warned that rates could rise sooner than markets expected.

The IMF had a couple of suggestions on how to further improve forward guidance, after the BoE in February started to focus more on measures of slack in the economy, rather than merely the unemployment rate.

One option would be for the MPC to publish its preferred path for interest rates, rather than making forecasts that are conditioned on market expectations as it currently does, thereby “removing a step that markets have to take to deduce the MPC’s thinking”.

Uncertainty around the interest rate path could be indicated by a fan chart, just as with the current GDP and inflation forecasts, to make it clear that the path is simply a projection rather than a promise.

Central banks for Norway, Sweden and the Czech Republic already do this.

But if BoE policymakers argued against providing a given path for interest rates, the Bank could show how its individual rate-setters place themselves relative to a median path – not unlike the Fed’s “dot” charts that have been in use since January 2012.

Some economists recommended this approach when the BoE overhauled its guidance in February.

Still, the IMF pointed out that there are many possible paths for interest rates that depend on all sorts of variables.

Picking the right one would need “target criteria” that might require clear statements about how factors other than inflation would affect judgement about desired interest rates.

Some of these, like financial market variables, might be outside the realm of standard monetary policy, and more in financial policy.

So far, few institutions have shown a willingness to be so transparent, and a move in that direction would require careful thought about interactions with (the Financial Policy Committee).

Earlier this year Carney talked of the need to “evolve” forward guidance, shortly before he revamped it.

The IMF’s message here is that the evolution of forward guidance at the Bank may have further to run.

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