What use is central bank Forward Guidance?

This week has seen a type of Forward Guidance by the UK Chancellor George Osborne and also by the Office for Budget Responsibility or OBR. Not only did the OBR decide that the outlook for the UK economy was somewhat brighter in spite of the fact that year on year economic growth has been slowing (2.9% to 2.3%)  it also found a pot of money down the back of its economic modeling sofa.

This reflects higher expected receipts from income taxes, corporation tax and VAT – some of which result from modelling changes to our NICs (National Insurance Contributions) and VAT deductions forecasts.

The change to the VAT model was considerable as the BBC points out.

The effect of correcting this error was considerable: it means an extra £11.5bn by 2020-21,

This brought things pretty much to the status of a farce as the “independent” OBR found that its economic model could finance the U-Turn on tax credits. But if we return to the OBR its Forward Guidance on the UK public finances is used as a benchmark officially and in the media without the skepticism I provide. They seem to miss the fact that it has provided mistake after mistake. These have been on fundamental matters such as the path of wages and the fact that we should have a fiscal surplus now rather than a likely deficit of over £70 billion. Accordingly its Forward Guidance only has one use which is to describe a situation which are incredibly unlikely to experience.

The Bank of England

A fundamental problem with Forward Guidance from the Bank of England is the same problem that the OBR has which is a sequence or litany of forecasting errors. Plainly guidance is of much more use if provided by those with seer like skills rather than those who have often been hopeless! But they continue to believe that they can sing along with Roger Daltrey and the Who.

I can see for miles and miles and miles and miles and miles
Oh yeah

Reality was once a friend of mine and all that. After all as it expected that unemployment would fall slowly it thought it would be safe to use an unemployment rate of 7% as a signal for Forward Guidance 1.0. You can argue as to how much of a threshold that 7% was but as unemployment rapidly declined through 7% then 6.5% then 6% then 5.5% the credibility of Forward Guidance fell with it. Along the way 1.0 got replaced by 2.0 after only 7 months. Actually you could argue 3.0 came in as well as the plan for reversing QE (no sniggering at the back please….) got revised further away. Actually that has been revised even further away recently as the Bank Rate threshold has shifted to 2% whilst the promises of a Bank Rate rise have remained just promises. I think everybody can see the problem with Forward Guidance that continually changes often fundamentally! We are at around version 9.0 now depending how you count each change.

On that road Bank of England Governor Mark Carney has since his Mansion House speech of June 2014 told us several times that Bank Rate will rise soon or in that instance “sooner than markets expect”. There have been two obvious problems with this which start with the fact that they haven’t and continue with the fact that he seems to alternate with saying low-interest rates will remain for a while. So they might go up or they might not Mark? Those who followed his advice about higher interest-rates and if you look at the remortgaging figures quite a few did may have food for thought next week if the ECB follows up its promises of a policy easing.

What does the Bank of England think?

Its underground blog has offered some thoughts today so it is time for us to hum along to The Jam.

I’m going underground, (going underground)

You may not be entirely surprised to learn that it offers a more favourable picture of Forward Guidance.

In this post we summarise results from our ongoing research on `Threshold-Based Forward Guidance’, whereby the policymaker links their decision to raise the policy rate from the lower bound to outturns for particular macroeconomic variables.

Interesting as of course this left rather a lot of egg on Governor Carney’s face when he tried it! Nonetheless apparently it is a triumph?

 We show that TBFG can improve welfare at the lower bound by increasing expected future inflation and, unlike forward guidance based purely on calendar time, by shrinking the variance of possible outcomes for inflation around the target.

There are quite a few warning lights flashing on the dashboard but let them continue.

Relative to forward guidance policies that only involve calendar time, TBFG performs much better because it builds in a commitment to provide additional stimulus should the economy turn out worse than expected and to remove stimulus should it turn out better.

Unless they can find someone who has been on the dark side of the moon for the past 7 years then I cannot think of anyone who would doubt the commitment of central banks to more stimulus. Also the latter commitment to remove stimulus has the unfortunate problem that nobody has actually removed stimulus yet in spite of many promises to do so. Maybe the US Federal Reserve really means it this time about December 16th but in 2015 it has cried wolf so far.

Also there is the issue of this.

improve welfare at the lower bound by increasing expected future inflation

They are of course free to offer to pay more for the goods and services they purchase but they can count me out! Actually in the UK “welfare” or real wages at the lower bound has been improved by inflation falling. This is the exact opposite of the scenario proposed. Awkward that.

Indeed reading the analysis it covers inflation rather than growth with something of an implicit assumption that they come together. Whereas the UK experience along with many others has recently been that a period of growth has come with both lower inflation and inflation expectations.

Oh and if we move from the world of economic models to the real one then the excerpt below found itself completely undermined by the fall in oil and commodity prices which began in late summer 2014.

by shrinking the variance of possible outcomes for inflation around the target.

How is that going with UK official CPI at -0.1%?

Comment

Earlier this year there was the debate over whether a dress was blue and black or white and gold which lit up the internet. The reality according to the BBC 4 documentary series on Colours is that our brains adjust what we see for consistency and that the dress saga was caused by that. For example the colour “banana yellow” is something of a misnomer as in fact they have a green tinge in the morning’s but our brains reject that. The trick with the dress was that what we thought we saw depended on the amount of light at that time.

Well central bankers see a white and gold dress all the time and that is their problem. Their economic models see inflation as a benefit pretty much everywhere and every time whereas the rest of us see a black and blue dress where inflation is in the vast majority of cases harmful. Or to put it another way it is pretty much the story of UK economic history. In that white and gold world Forward Guidance is a benefit and maybe there are  a few circumstances where the light is correct and they are right, but in general they are wrong as the dress is black and blue.

 

 

 

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26 thoughts on “What use is central bank Forward Guidance?

  1. Shaun,super post today.

    It’s one of the real strengths of this blog that you examine the facts and don’t take the CB theories at face value like they want you to.

    I’ve said many times that the politicians and central bankers are sleepwalking us into a wider currency/economic crisis.The reason they’re being allowed to is that there’s so little genuine scrutiny of what they’re up to.

    You’ve laid out,in the sort of detail you normally do,how forward guidance has been anything but.What grates with me is all these mainstream news feeds that provide so little genuinely indepedent analysis of what’s gone on despite the money they’re all on.The BBC,particularly,given it’s public service remit is beyond shocking.They regurgitate BoE press releases as if they’re news and tritely push govt lines on house prices going up being good for the economy.

    If you want to read a decent deconstruction of reality then you have to come to relatively low traffic-no disrespect intended-blogs like this,Mish Shedlock,David Stockman,Paul Hodges,Steve Keen or Martin Armstrong.

    Every day I come here,I learn.Keep up the good work.

    • You are absolutely right that the mainstream media could find all this out and report it, but don’t. The BBC simply puts things into the following buckets and reports accordingly:
      1. Bad things. These include Jeremy Corbyn, Tories, fracking, big business, austerity, climate change deniers, UKIP, Israel, privatisation, Republican politicians in USA, gun laws in USA
      2. Good things. These include the NHS, charities, climate change advocates, right wing labour politicians, comedians who offer political views
      3. Awkward things (previously in category 2 but, embarrassed by the contrary weight of opinion and evidence, tricky to deal with). These include the EU, immigration, the SNP, Kids Company.
      4. Complicated things. These include the difference between debt and deficit, QE, BofE guidance. These have been relegated to the attic and are no longer discussed.

      • James , that is a great summary

        and on the ITV hand we have

        1, celebrity news

        2, more celebrity news

        3, shocking pictures of the world

        followed by

        4, more celebrity news , inc kitten videos

        As for Sky

        much the same with a slice of “buy sky’s expensive products”

        the rest of MSM are mostly copy & paste scribblers

        you have to hunt for sites like Shaun’s to get to what’s really going on

        Forbin

      • Bravo, James. I think in Canada you could use the same categories for the Canadian Broadcasting Corpn and even a lot of the items in them would be the same.

      • Almost right, but as a Scot, may I respectfully correct you on the SNP; there were a number of protests at BBCScotland’s HQ, attended by thousands, at BBC’s anti-Independence propaganda.

        Roger Harrabin now calls climate sceptics, “CONTRARIANS”!!!

  2. Hello Shaun,

    I must be mistaken

    “…their problem. Their economic models see inflation as a benefit pretty much everywhere and every time ….”

    But they did not always see it this way – since the 2008 crash perhaps?

    they are lost and need to go back to the ordinary real world

    What has happened to it all?
    Crazy, some are saying
    Where is the life that I recognize?
    Gone away

    But I won’t cry for yesterday
    There’s an ordinary world
    Somehow I have to find
    And as I try to make my way
    To the ordinary world
    I will learn to survive

    Duran Duran

    learning to survive , aye thats the real issue here

    Forbin

    PS : Forward Guidance – what we’d like to do, but won’t

    • Hi Forbin

      The switch you correctly point out from inflation being an “evil” to a “saviour” came about when central banks spotted that the rising debt burden was out of control. They did not apply Forward Guidance and think ahead instead they watched the economic world come crashing around their ears.

      They then thought they had to do “something” but of course their ability to do real things is limited so they try to change appearances and use inflation (letting it overshoot, nominal GDP targeting, talking of raising the inflation target,Forward Guidance etc…) and hope people will be fooled into thinking it is a wealth increase. The catch is that many are taking the advice of Pete Townsend.

      Won’t Get Fooled Again

      • The majority of voters need to be criticised here. They keep voting for the same incompetent politicians. They fail to punish liars. The truth about what it takes to balance spending is available, but few are even prepared to debate this. Trivia about cuts gets shouted IE “dog whistle politics” while the big money wasting items are swept under the carpet.

        And the worst part is that even now, modest & sensible spending restraint could bring a modest pain recovery for Western Europe with a good outcome. But with the head in the sand keep borrowing because we won’t admit we aren’t as rich as we would want -> will probably result in a much more severe and painful economic downturn / crisis.

        failing to plan is planning to fail.

  3. Forgot to make my point….,. 🙂

    There are stories from good sources that the Fed is looking to raise rates to bail out the pension funds.

    They aren’t doing it because the recovery is strong but because of the unintended consequences of ZIRP/QE driving down yierlds and pushing liabilities higher.

    If the Fed raises then all hell could break loose.

    And this is the sad thing.We pay an awful lot for the Board of governors at the BoE and I have to ask what they’re actually doing for their money,besides backstopping RBS’s woeful mortgage book that’s still haemorrhaging cash 7 years after they got bailed.

    As far as I can see,they’ve performed poorly at every turn.
    1)ZIRP hasn’t worked
    2) QE hasn’t worked
    3) They failed to foresee 2007/8
    4) FLS failed in it’s supposed remit.
    5) Forward guidance is just utter bull****,given they’ve gone back on it so many times.
    6) They’re now playing a pssive part as the good ship UK heads towrds the next iceberg.

    On the ONS side
    1) they’re actively failing to record inflation properly
    2) and ditto GDP-imputed rents etc

    Given how crap the BoE are,couldn’t we just replace them with one person.They’d still fall asleep at the wheel but at least we wouldn’t be paying 9 of them.

    • I’ve been reading the same things about the Fed’s motivations but I think their economy is stronger than you think (Not that it’s in glowing health) but the real problem is if the raise comes, watch the dollar go through the roof, followed by the inevitable economic crash unless productivity suddenly sprints away which I don’t see happening.

      Then there’s second order effects in Em Mkt debt denominated in dollars although the relevant authorities seem relaxed and have been telling the Fed to “just do it”. I suspect the Em mkt authorities want a straightener and intend to let poor companies go to the wall which they can then blame on the Fed.

      On the BOE I think your suggestion would result in over staffing – the Office cat would do as good a job and would only want paying in Whiskas.

      • Hi Noo2

        There would be plenty of money to feed the cat with champagne and caviar if he/she wanted!

        As to pension funds in Europe think how they are going to feel if Mario Draghi cuts to -0.3% or -0.4% next week as he keeps hinting? Meanwhile the US Dollar Index is back above 100 compared to the recent nadir of a dip below 80 in May 2014.

        • I should imagine European Pension Funds are already counting the years to “going bust day”.

          If the Fed raises, just watch the dollar go higher – it has been at 164 in the past……

    • Hi Dutch

      Yes that nursery rhyme has quite a few applications these days. It could apply to Syria as we seem to have threatened to bomb both sides so far! Actually as there are so many competing influences there maybe more than two sides…

      Also I wanted to reply to your pension liabilities point as I ahve just done so to Noo2. Next week Mario Draghi has heavily hinted at an ECB cut to -0.3% and maybe -0.4%, what about Euro area pension liabilities then?

  4. Hi Shaun

    You have posed a rhetorical question the short and simple answer to which is “None”.

    However, this does not express the whole of it. That a major institution can come out and suggest, as you say, and imply that inflation is an addition to welfare is such egregious drivel as to almost defy belief. I do not mind them being wrong about forecasting because that is understandable but to treat us like idiots, as they do, is not.

    It seems to me that the leitmotif word for the BOE – and many other institutions these days is: “Fake”. There is little honesty, intellectual or otherwise, in any discourse these days and we are fed on a diet of deception and obfuscation the object of which is to disguise the truth and avoid what may be hard choices. You do not need to be omniscient these days to see that we have major economic and political problems at hand but we appear to have pygmies on the levers of power and influence; in this respect the BOE are simply part of a piece.

    • Hi Bob J

      It pretty much comes down to Forbin’s point which is that inflation has switched from being bad to good. In fact the official mantra is that inflation in house prices is the best thing since apple pie. Of course via FLS the Bank of England lit the blue touch paper for it and they are supposed to be controlling it.

      As to the forecasting errors I agree that some leeway should be applied. But the catch is that they keep placing policy on forecasts much further ahead than they can see especially with their record.

  5. Great column as usual, Shaun.
    There was a discussion paper on forward guidance released by the Bank of Canada earlier this month.
    http://www.bankofcanada.ca/2015/11/staff-discussion-paper-2015-15/
    It was authored by the lovely and charming Lori Rennison and her colleague Karyne Charbonneau. I met Lori some years ago when she and a male colleague gave a presentation at Statistics Canada. Lori uses the term “state-contingent forward guidance”, which seems to me to be a more precise term that the BoE’s “threshold-based forward guidance”. There are no hard thresholds in the BoE’s forward guidance policy from February 2014 forward, but it is state-contingent, at least in theory, in basing itself on a plethora of measures based on spare capacity.
    Note that Lori is much too kind to the BOE’s August 2013 forward guidance policy, maybe not so strange since she served under Mark Carney when he was at the Bank of Canada. There is no mention that the announcement of the forward guidance policy had the immediate and perverse effect of strengthening the pound. Or perhaps she just doesn’t read your masterful blog of August 8, 2013, “How Mark Carney tightened UK monetary policy yesterday” or your related postings.
    In a lot of the Canadian press, Mark Carney is still eulogized as the father of forward guidance. Lori notes that he should more accurately be regarded as the father of time-contingent forward guidance, based on his April 2009 announcement when he dropped the overnight rate that it “would remain at its current level until a specific date, conditional on the outlook for inflation”.
    For Mark Carney, his glory moment as a central bank governor came barely more than a year into his term as Governor of the Bank of Canada and the six years plus since then have been anticlimactic.

      • Hi Andrew

        Thank you for the link which I have been reading. After some cheerleading for Forward Guidance I did not this bit.

        “Overall, there is somewhat mixed empirical evidence in support of
        the effectiveness of forward guidance at the ELB. In particular, as Table 2 suggests, forward guidance tends to have short-lived effects on short-term rates, and its impact is larger when it is implemented on a targeted basis, clearly communicated and clearly tied to the central bank’s policy goal. ”

        Ah “somewhat mixed” so like easing Forward Guidance is believed but tightening Forward Guidance less so……….

  6. Hi Shaun, great stuff again. Alice would be very confused. Of course the Cheshire Cat in the office might tell her that there is nothing wrong with the models, or the forecasts – the problem is with reality.

    • Hi Eric

      I guess there is an alternative universe somewhere where all this actually works, but not this one. Are central bankers playing out the episodes of Star Trek where people find themselves in the wrong universe?

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