March 9, 2014 6:57 pm

Forward guidance threatens to ‘encourage excessive risk’

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Efforts by central banks to spur economic recovery by providing guidance on what will happen to interest rates could endanger the global financial system, economists at the Bank for International Settlements have warned.

Investors are being encouraged to load up on risk because they believe forward guidance will warn them well in advance about any rise in interest rates, according to research published by the Basel-based institution known as the central bankers’ bank.

The strategy could also result in rates remaining too low for too long because central banks fear the reaction of markets to any rate rise, fuelling even riskier behaviour.

The guidance, which all four of the leading central banks have undertaken, could raise the threat of “an unhealthy accumulation of financial imbalances”, economists Andrew Filardo, who heads the BIS monetary policy unit, and Boris Hofmann argue. It could also cause panic if investors believe the guidance had changed unexpectedly.

The findings raise questions over the Bank of England’s use of forward guidance.

Mark Carney, the BoE’s governor, made guidance his big idea to revive the British economy when he took over last year. In August, the bank pledged to keep the bank rate at its current record low of 0.5 per cent at least until unemployment fell to 7 per cent. Mr Carney has faced criticism after unemployment fell far more quickly than expected, raising the prospect of rate rises more than a year ahead of the mid-2016 date implied by the Monetary Policy Committee’s original forecasts.

The US Federal Reserve began using guidance on interest rates in 2008, and the Bank of Japan and the European Central Bank followed suit in 2010 and mid-2013 respectively.

The BIS economists said the perception that the Fed had unexpectedly changed its guidance in mid-2013 was to blame for the turmoil in emerging markets that followed comments from Ben Bernanke, then the central bank’s chairman, that the $85bn monthly asset purchases programme could be reduced.

If markets became focused on certain aspects of guidance, a broader interpretation or suggestion of a change of policy could lead to panic, the economists said. They added: “The global market developments last May and June in response to the Federal Reserve’s tapering communication highlight such a risk.

“In that episode, financial markets fundamentally reassessed the path of future interest rates in the United States, and a global bond market sell-off ensued, along with a break in equity markets and a sharp depreciation of some emerging market exchange rates.”

The economists warned that a more worrying development would be if guidance made central banks so concerned about investor reactions to their communications that they delayed raising rates.

“This could translate into an undue delay in the speed of monetary policy normalisation,” the economists said, adding that this could heighten the threat of asset bubbles.

“The mere perception of this possibility, over time, could encourage excessive risk-taking and thereby foster a build-up of financial vulnerabilities.”

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