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.