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July 7, 2013 3:15 pm
The ECB president set no specific date when the period of low interest rates would end. Nor did he post any conditions that would trigger an automatic exit from the policy of zero interest rates. He did not say the ECB would keep interest rates low once a recovery gets under way, or once inflation rises above target. I expect Mark Carney, governor of the Bank of England, to announce a more detailed version of forward guidance in August. But Mr Draghi’s version of forward guidance is unbelievably vague. It is more like a forecast than a commitment – which is something completely different.
The original concept of forward guidance goes back to papers written by the economists Paul Krugman in 1998 and Gautti Eggertsson and Michael Woodford in 2003. It deals with how a central bank can get long-term interest rates to fall at a time when short-term rates – over which it has control – are close to zero. Forward guidance is not merely a promise to keep rates low. It is a promise to keep them lower for longer than is warranted.
The act of pre-committing future policy to be inconsistent with future inflation targets is absolutely central to this idea. It is the opposite of what central bankers normally do. In the case of the ECB, it is not even clear whether a policy that consciously violates the price stability target is legal under European law.
Why would such a policy be justified on economic grounds? If central bank interest rates are stuck at the zero bound, as they have been for a while now, they are most likely higher than they would otherwise be if no such bound existed. To compensate for the fact that rates are, therefore, too high today, the central bank can decide to pre-commit to err in the opposite direction in the future. Such symmetry may be hard to achieve in practice. But if the announcement is credible, investors gain certainty about the future path of short-term rates, which, in turn, would translate into lower long-term rates.
But this policy requires an unusual degree of clear commitment. From today’s perspective, it is forward looking. But from tomorrow’s perspective, it is backward looking – “backward guidance” if you like – because you set policy to fulfil a promise you made in the past. This is a feature, not a bug.
There are various ways to do this in practice. The central bank could simply commit itself to a fixed time during which it keeps rates near zero. But it may not get the benefit of lower long-term rates if markets perceive this timeframe to be too short or too long. A better way would be a set of exit conditions, for example targets for inflation and unemployment rates, such as those which the Fed has set out.
Mr Draghi, by contrast, said the ECB’s governing council will determine future policy on the basis of an unchanged policy framework and an unchanged price stability target. This means that if a future governing council sees inflationary pressures rising, they will raise interest rates just as they did in the past. I accept that they may move a bit more slowly next time, and not repeat the error they committed two years ago when they raised rates prematurely.
This is good, but not really surprising. The only new information I am taking away from Mr Draghi’s statement is that the ECB is even more pessimistic about the economy than I am. Until last Thursday, I did not think this was possible.
The bluffers’ version of forward guidance is also risky. In a paper presented at the Jackson Hole central banking conference last year, Professor Woodford highlighted a theoretical case in which a poor strategy of forward guidance backfires. If the markets interpret a promise to keep rates at zero for a certain period as a statement that the recovery path is weaker than the markets had anticipated, all bets are off. It could be understood to imply that future real incomes would be lower, and that recognition itself may well drive the economy further into recession.
That scenario may well apply in this case. The ECB’s version of forward guidance has exactly this described downside – and hardly any upside. If the economy remains stuck in the liquidity trap, eurozone interest rates would remain low whether you have forward guidance or not. But if that forecast turns out to be false and the economy recovers, a future governing council will not feel bound by a vague promise of the past. Mr Draghi’s commitment is sufficiently flexible to allow that interpretation. In other words, his version of forward guidance will either turn out to be unnecessary or it will be quietly swept away.
Mr Draghi should either drop the whole idea, or persuade his governing council to make the pre-commitment stick by adding a set of exit criteria. Until and unless that happens, it is best to treat this version of forward guidance as a bluff.
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