Forward guidance, time inconsistency, and monetary policy

Today’s commentary

Over the past few months, the world’s central banks have turned to forward guidance as a central focus of monetary policy. This tool is untested as a central component of monetary policy and has been thrust into the spotlight only because we are at or near the zero lower bound. I believe credibility to prevent time inconsistency and markets’ frontrunning central banks will be a major theme going forward. In Europe, default and redenomination risk present special challenges.

Before the crisis, policy rates were much higher everywhere in developed economies. However, the magnitude of the financial crisis caused central banks to slash interest rates aggressively – so much so, that rates can be cut almost no further. Japan was already at the zero lower bound when crisis hit. As such, its experience has become a cautionary tale. In the early 1990s, Japan’s economy crashed but rebounded successfully. Japan’s rebound came unstuck in 1997, however. And when the economy lapsed into recession, deflation took hold.

Elsewhere in developed economies, initial reflation efforts following the crisis were successful. But as time has gone on, inflation and inflation expectations have receded. In Europe, the threat of deflation has taken form. Sweden already has deflation. And in the eurozone periphery, deflation has also taken hold. Policy makers are concerned because Japan’s longstanding consumer price deflation represents a negative example of what deflation could mean. Debts become more burdensome, crimping aggregate demand as the private sector deleverages to reduce debt stress. In Europe, in particular, this is problematic because the lack of currency sovereignty means that sovereign governments fear loss of market access and soaring interest rates on government obligations. In turn, governments are thus limited in their ability to ease private sector debt stress and reflate the economy via the deficit spending route. Quite the contrary, governments in Europe are adding to the economic deflation by reducing government expenditure at the same that time the private sector is retrenching.

Clearly then, this thrusts central banks into a central policy role, particularly in Europe where sovereign governments’ hands are tied by a lack of currency sovereignty. But, with interest rates at or near zero percent, central banks are out of bullets on interest rate policy. This is why they have turned to unconventional monetary policy.

Federal Reserve Chairman Ben Bernanke put it this way last October:

In normal circumstances, the Federal Reserve implements monetary policy through its influence on short-term interest rates, which in turn affect other interest rates and asset prices…

Following this standard approach, the Fed cut short-term interest rates rapidly during the financial crisis, reducing them to nearly zero by the end of 2008–a time when the economy was contracting sharply. At that point, however, we faced a real challenge: Once at zero, the short-term interest rate could not be cut further, so our traditional policy tool for dealing with economic weakness was no longer available. Yet, with unemployment soaring, the economy and job market clearly needed more support. Central banks around the world found themselves in a similar predicament. We asked ourselves, “What do we do now?”

To answer this question, we could draw on the experience of Japan, where short-term interest rates have been near zero for many years, as well as a good deal of academic work. Unable to reduce short-term interest rates further, we looked instead for ways to influence longer-term interest rates, which remained well above zero… Since 2008, we’ve used two types of less-traditional monetary policy tools to bring down longer-term rates.

The first of these less-traditional tools involves the Fed purchasing longer-term securities on the open market–principally Treasury securities and mortgage-backed securities guaranteed by government-sponsored enterprises such as Fannie Mae and Freddie Mac. The Fed’s purchases reduce the amount of longer-term securities held by investors and put downward pressure on the interest rates on those securities… Lower mortgage rates are one reason for the improvement we have been seeing in the housing market, which in turn is benefiting the economy more broadly. Other important interest rates, such as corporate bond rates and rates on auto loans, have also come down. Lower interest rates also put upward pressure on the prices of assets, such as stocks and homes, providing further impetus to household and business spending.

The second monetary policy tool we have been using involves communicating our expectations for how long the short-term interest rate will remain exceptionally low. Because the yield on, say, a five-year security embeds market expectations for the course of short-term rates over the next five years, convincing investors that we will keep the short-term rate low for a longer time can help to pull down market-determined longer-term rates. In sum, the Fed’s basic strategy for strengthening the economy–reducing interest rates and easing financial conditions more generally–is the same as it has always been. The difference is that, with the short-term interest rate nearly at zero, we have shifted to tools aimed at reducing longer-term interest rates more directly.

Last month, my colleagues and I used both tools–securities purchases and communications about our future actions–in a coordinated way to further support the recovery and the job market. Why did we act? Though the economy has been growing since mid-2009 and we expect it to continue to expand, it simply has not been growing fast enough recently to make significant progress in bringing down unemployment… So the case seemed clear to most of my colleagues that we could do more to assist economic growth and the job market without compromising our goal of price stability.

After forays in the U.S., the U.K., and Japan into the first unconventional policy tool, quantitative easing, with which the central bank makes large scale asset purchases, more and more central banks are coming to rely on the second policy tool, forward guidance. The US Federal Reserve, the Bank of Canada, the Bank of England, the Bank of Japan and the European Central Bank have all begun to rely heavily on forward guidance to bring down long-term interest rates in order to add policy stimulus.

Forward guidance is problematic as a policy tool however because central banks face time inconsistency problems as decision makers. If one looks up the term time inconsistency on the Internet, the Wikipedia entry pops up as a reasonably good place to start for understanding the term. The Wikipedia entry reads:

In the context of game theory, dynamic inconsistency is a situation in a dynamic game where a player’s best plan for some future period will not be optimal when that future period arrives. A dynamically inconsistent game is subgame imperfect. In this context, the inconsistency is primarily about commitment and credible threats. This manifests itself through a violation of Bellman’s Principle of Optimality by the leader or dominant player, as shown in Simaan and Cruz (1973a, 1973b).

For example, a firm might want to commit itself to dramatically dropping the price of a product it sells if a rival firm enters its market. If this threat were credible, it would discourage the rival from entering. However, the firm might not be able to commit its future self to taking such an action because if the rival does in fact end up entering, the firm’s future self might determine that, given the fact that the rival is now actually in the market and there is no point in trying to discourage entry, it is now not in its interest to dramatically drop the price. As such, the threat would not be credible. The present self of the firm has preferences that would have the future self be committed to the threat, but the future self has preferences that have it not carry out the threat. Hence, the dynamic inconsistency.

With central banks, the problem with forward guidance is that they can give all the guidance they want but if the conditions on the ground change, the guidance will change. And everyone knows that. The dilemma for getting forward guidance to have an impact on expectations then is convincing markets that the central bank is going to stick to its guidance despite its desire to deviate. If a central bank’s forward guidance loses credibility, markets will discount any guidance from it, front-run their decisions, and the central bank will lose all influence over long-term interest rates.

Below I have some thoughts on how central banks can (and probably will) deal with this problem, the special problems in the eurozone, and what all this means for investors.

A perfect example of time inconsistency is the ECB’s last rate cut. The cut was unexpected and, as such, sparked speculation that it was controversial within the ECB. It’s the fact that it was unexpected which highlight’s the ECB’s time inconsistency. Before the rate cut, nowhere in commentary by ECB officials was a cut mentioned. More than that, nowhere was there undue concern about economic risks like deflation that led to the cut. So clearly, the ECB either erred in its communications strategy – or events on the ground developed so quickly that the ECB was forced to change its policy stance, precipitating the cut. The latter explanation makes the most sense and is a perfect example of the dynamic inconsistency of the ECB’s reaction function and dynamic feedback loop between policy and the economy which helps create that inconsistency.

Now imagine that the ECB had been changing the basis for its forward guidance instead of lowering the policy rate. Then the ECB would be in the untenable position the Fed finds itself in right now.  Having decided to largely jettison QE in favour of forward guidance, the Fed found its policy communications strategy woefully lacking. The markets threw up all over the tapering talk and the Fed was forced to backtrack on its tapering timetable. The reason Bernanke and his colleagues have been at pains to stress that the adjustment path to QE could be UP OR down is because they were shocked at how violently markets sold off after the taper talk. But by stressing the volatility of the Fed’s reaction function, the Fed has simply undermined the usefulness of forward guidance as a policy tool and invited markets to question and front run their guidance.

In my view the recent Fed papers by French and Wilcox further muddy the waters, reducing the Fed’s credibility on forward guidance. In essence, these papers suggest the Fed tell the markets that the Fed is doing a mea culpa, that the Fed’s previous guidance was wrong, and that the Fed is now fixing that guidance. This is a classic case of dynamic inconsistency and a perfect invitation to question the accuracy of the Fed’s forecasts and the credibility of the Fed’s future policy statements.

Apparently someone at the Fed understands this problem. And so while there is talk of adjusting the forward guidance, there is also talk of adding a different threshold for guidance in addition to the one using the unemployment rate as a threshold. I would support a low-rate peg and wrote yesterday’s post on the deflationary forward guidance threshold to explain why. If the Fed chooses to introduce time inconsistency into its guidance, then I fully expect forward guidance to fail as a policy tool, meaning I do not expect the Fed to gain control over long-term rates.

If the Fed loses control over long-term rates with its forward guidance and the economy softens, the Fed will be forced to turn back to QE – but in a more aggressive form. Three years ago, back in November 2010 as QE2 was just beginning, I outlined some of the things the Fed might do if it were aggressive, like buying municipal bonds, or buying only long-duration assets or explicitly targeting a specific medium- or long-term interest rate with QE (what I call rate easing). These options will be on the table if the Fed’s forward guidance gambit fails.

In Europe, the ECB faces a special challenge because redenomination and default risk in Europe is unique. When the ECB lowers interest rates, this feeds through in full measure only to the eurozone risk free asset class. German bonds represent the risk free asset, with other sovereign obligations subject to various degrees of liquidity, default, and redenomination risk premia. So Germany will always enjoy the full effect of policy easing, while the transmission of the ECB’s policy elsewhere will be partially or fully-blocked by liquidity, default and redenomination risk.

For example, with the ECB’s rate cut, Italy is enjoying record low short-term rates for borrowing on its sovereign obligations. Where the interest rate on one-year paper had been about 1% in October, it fell to below 0.70% in the aftermath of the rate cut. On the other hand, the yield on the Italian 10-year is 235 basis points higher than the equivalent ten-year as redenomination and default risk remain elevated in Italy. That means that Italian banks buying Italian sovereign bonds have to either stick to the short-end of the curve or take a risk on the long end. If Italian yields break out to the upside, the balance sheets of Italian banks will be savaged by their chasing long duration yield. And the spectre of bank bailouts will precipitate a crisis in Italy that can only end badly.

What can the ECB do then? The only thing it can do at this point in my view is QE. Just yesterday, the ECB’s chief economist Peter Praet told the Wall Street Journal that all options were on the table at the ECB, including negative interest rates and quantitative easing. This is an extraordinary move to the dovish side. Right now, the US central bank is attempting to exit QE while the ECB is cutting rates, aggressively moving into forward guidance, and talking up negative rates and QE. If anything the ECB is now more aggressive than the Fed. While the lower multiples in Europe have always made European equities attractive relative to American ones, the ECB’s hawkish policy created downside risk. Now that risk is removed with the real risk in Europe coming from the real economy.

Ultimately, if deflation takes hold in the periphery, the ECB’s buying up periphery assets using QE in addition to just using forward guidance may be necessary if it wants to truly eliminate redenomination and default risk. But the intervention from Hans-Werner Sinn and the recent talk in the German press of the ECB as the Bank of Italy, engaging in expropriation and theft, tells you that such a move is fraught with extreme political risk.