The ECB has reviewed its own forward guidance in a global context. Forward guidance uses communication [i] to add monetary accommodation at the zero bound for policy rates and [ii] to contain interest rate volatility. The ECB sees its own version as ‘form of qualitative guidance conditional on a narrative’. It is a commitment to keep policy rates very low over a flexible horizon, based on a wide array of indicators supporting a subdued inflation outlook over the medium term. This is different from the Federal Reserve or the Bank of England, which use more quantitative outcome-based forward guidance.
This is a follow-up to the initial post on “Understanding ECB forward guidance” (view post here).
Why have central banks globally introduced forward guidance?
“Providing more direct signals about the short-term future evolution of the policy rate has long been in the monetary policy toolkit…However, its use was limited in scope [prior to the great financial crisis]… One exception to this was the practice…of regularly publishing [the] projection of the future path of the policy rate. In particular, the Reserve Bank of New Zealand adopted this practice in 1997, followed later by Norges Bank and Sveriges Riksbank.”
“The financial crisis…turned central bank conditional communication on the path of the policy rate into an additional instrument for crisis management…as the level of the policy rate is already very low and because economic actors may find it harder to infer the likely future path of policy rates from past regularities.”
“Forward guidance can serve two purposes…
- First, the aim…may be to introduce greater monetary policy accommodation when the policy rate reaches the interest rate lower bound…[by putting] downward pressure on longer-term interest rates.
- Second…[it] may be aimed at preventing market volatility – in particular interest rate volatility – from influencing the monetary policy stance.”
How has forward guidance been implemented in practice?
“Different central banks have adopted different forms of forward guidance. The following four categories…can be distinguished…:
- Pure qualitative forward guidance has no explicit end-date or numerical thresholds…and no explicit reference to a configuration of underlying conditions…which would justify this evolution. Examples include the forward guidance provided by the Federal Reserve System in 2003, when it stated that ‘policy accommodation can be maintained for a considerable period’; the Federal Reserve used similar statements at the start of the crisis in 2008-2009.
- Qualitative forward guidance conditional on a narrative provides qualitative statements about the likely evolution of policy interest rates complemented by a description of a combination of macroeconomic conditions…An example of this is the ECB’s formulation adopted on 4 July 2013…This type of forward guidance was also used before the crisis, in particular by the Bank of Japan in April 1999, when it declared that it was committed to a near-zero interest rate policy ‘until deflationary concerns would be dispelled’.
- Calendar-based forward guidance entails making a conditional commitment based on the explicit date after which the stance of monetary policy is expected to change. For example, the Bank of Canada introduced calendar-based guidance in April 2009 with its statement that ‘conditional on the outlook for inflation, the target overnight rate can be expected to remain at its current level until the end of the second quarter of 2010’. The Federal Reserve also applied calendar-based guidance in 2011.
- Outcome-based forward guidance with explicit numerical conditions or thresholds…link[s] central bank actions to…economic variables. The Federal Reserve…has moved to a form of outcome-based guidance with numerical thresholds on unemployment and inflation since the end of 2012. The Bank of England also introduced outcome-based guidance in August 2013 based on an explicit numerical threshold on unemployment.”
Why did the ECB introduce forward guidance in July 2013?
“Providing forward guidance has been a material shift in the ECB’s communication on monetary policy. It has implied communicating not only how the ECB’s Governing Council assesses current economic conditions and the risks to price stability over the medium term, but also what this assessment implies for its future monetary policy orientation.”
“The Governing Council’s decision to provide forward guidance was driven by the need to anchor market expectations of the future evolution of key ECB interest rates… The ECB’s forward guidance has been designed around the following elements…
- The Governing Council’s expectation about key interest rates is based on the subdued outlook for inflation extending into the medium term, which is fully consistent with the ECB’s primary objective of maintaining price stability in the euro area and with the Governing Council’s aim to keep inflation below, but close to, 2% over the medium term…
- The ECB’s reference to an ‘extended period of time’ in its forward guidance formulation constitutes a flexible horizon, which neither has a pre-determined end-date, nor relates to explicit quantitative thresholds.
- The ECB’s forward guidance is complemented by the description of the underlying conditions…taking into account a host of economic and monetary variables…[For example] on 6 March 2014 the Governing Council explained that ‘this expectation is based on an overall subdued outlook for inflation extending into the medium term, given the broad-based weakness of the economy, the high degree of unutilised capacity, and subdued money and credit creation.’
- The ECB’s forward guidance is provided in relation to a multiple set of interest rates rather than a single interest rate. This feature derives from…the operational framework of the ECB, which offers two standing facilities to its counterparties: the marginal lending facility and the deposit facility.
- The ECB started to provide forward guidance prior to exhausting the room for further rate cuts… The ECB’s forward guidance acknowledges the possibility that key ECB interest rates may be reduced further depending on the outlook for price stability. This ‘easing bias’ in the forward guidance formulation is an important element.”
Has ECB forward guidance worked so far?
“The announcement of 4 July 2013 triggered an immediate flattening of the money market curve, with forward rates declining by around five basis points at maturities over six months…Besides the immediate market reaction, the ECB’s forward guidance also led to a lasting decline in market uncertainty about the path of future short-term interest rates. Implied densities extracted from EURIBOR options and used to gauge expectations of the forward OIS rate show that the dispersion of short-term rate expectations has declined… Since the announcement of forward guidance, the sensitivity of money market forward rates to macroeconomic data releases has declined and has become more consistent with historical averages.”