Forward Guidance: Should the SNB have shocked the world?Posted: January 22, 2015
There has been a very public divergence in central bank practice this week.
For six months, the European Central Bank (ECB) has been slowly building towards an expected announcement implementing Quantitative Easing (QE) in the Eurozone. Carefully tailored releases and winks have unsubtly alerted the markets that QE was coming to Europe and that market actors better be prepared.
By contrast, the Swiss National Bank (SNB) shocked the markets with a surprise announcement that it would be both abandoning their 3 year-old currency peg to the Euro and cutting interest rates. The effects have been likened to a future “nuclear explosion” [Logutenkova & Vögel; 2014], with immediate impacts including a 41% increase in the Swiss Franc against the Euro and a 20% decrease in Credit Suisse’s stock price.
Whilst it is clear that the policies themselves are debatable, the issue to be discussed here is not centred on evaluating economy management strategies.
Rather this week has highlighted a broader question: what is the best style for central banks to take action? Should banks use a long lead-up time to corral market agents into calmly closing arbitrage opportunities and perhaps suffer a reduced impact of their actions? Or should they hide their planning and shock economies into a given direction and risk volatilit and credibility?
This piece shall first explore what is the currently recommended practice and critique it. Subsequently we will look into the merits of the alternatives and attempt to highlight the best approach.
Traditionally, central banking operations were strictly on a “need-to-know” basis. Decisions and actions were designed in secret, the processing was cryptic, and the actioning a surprise.
However since the late 1980’s there has been an evolution in practice, with the Reserve Bank of New Zealand, the Bank of England, the Norges Bank leading the way.
Aligned with the greater financialisation of economies and the continued rise of the New Macroeconomic Consensus (NMC), greater emphasis has been placed on openness. The argument being that “…a more open central bank…naturally conditions expectations by providing markets with more information…thereby creating a virtuous cycle.” [Blinder et al; 2008]
Central banking became no longer focused on simple tools/results terms. Rather it was about managing market expectations with purposeful announcements to achieve more rounded goals. This being the case, the more information and reasoning given to markets, the more efficient central bank policy.
The importance of announcements has risen such that some argue it is the pre-eminent tool available to policy makers. [.ibid]
The Taylor Rule, the recommended NMC methodology for setting interest rates, fits naturally in this practice. The mechanical nature of the calculation strips it of all latitude. So by publicly announcing that this method will dictate interventions market participants have access to the very thinking method of policy makers.
However the characteristic subtlety of policymakers was not completely abandoned. This style of announcement was named “forward guidance”. The information being shared illustrates the thinking of central banks and their likely future plans. It is an insight – not a promise, nor guarantee.
Thus far it seems that the merits of the practice have far outweighed its downsides. As long as banks are careful and consistent in their announcement strategy, the use of surprise interventions become unnecessary and potentially harmful.
So, why did the SNB break away from the orthodox style? Their very announcement of the indefinite currency of the peg three years ago whiffs of forward guidance intention. Why would they weaken the credibility with such a massive shock? The following sections shall explore the key criticisms of the practice, as they may offer an explanation for why the SNB chose to intervene in such a way.
The true power of forward guidance rests with a bank’s credibility. Market actors have to truly believe that banks will act as they say for the economy to be guided as intended.
Hence a major criticism of forward guidance lies in its very character. It is not a promise, nor guarantee – and only the credibility of the bank will dictate the effectiveness of the policymakers.
However policymakers operate in a dynamic world and must react dynamically to world events. Thus there is a natural conflict. Central banks can attempt to guide markets, but such guidance is based only on existing knowledge and interpretation. It cannot be completely infallible throughout time and policymakers may (will) need to reverse policy in the case of unforeseen events and poor projections.
Any attempt for central banks to rectify their forward guidance potentially ruins their credibility. Without their credibility they become neutered. So central banks are stuck between positive corrective action and maintaining their credibility. This trade-off encourages greater volatility in turn and weakens the powers of policymakers.
Once it was widely acknowledged that every policymakers’ wink and hint provides a mine of potential insight, a rational fetishisation of the information occurs. Misinterpretation becomes a massive threat and increasingly ever more likely. The occurrence of misinterpretation creates feedback loops which encourage greater volatility.
Additionally, gaps in bank communication occur – both unintentionally and intentionally. As highlighted by Bernanke , in the case where there are gaps in the market’s knowledge of central banking thinking, markets make estimations. These estimations compound the misinterpretation feedbacks, and can actually outweigh/contravene outstanding forward guidance. Thus making it less likely that the original intent of the central bank can be fulfilled.
Whilst it may seem that the counter argument of more openness may be the answer, it is clear that such a series of likely incidents will only encourage more immediate volatility. This in turn will just damage the credibility of the central bank to the detriment of the methodology itself.
Arising from monetarist rhetoric, some authors have suggested that the only way central banks can effect the economy is through manipulating money supply. Aligned with this is the Lucas Critique, which suggests that policy can be neutered as agents adapt to counteract central intention.
Thus surprise becomes key – central bankers must act with as little warning as possible to maximise the power of their intervention. [Cukierman and Meltzer; 1986]
The tradeoff here however is inflation driven by the created volatility in money supply. As markets adjust, inflation will occur as (in standard theory) agents digest available information and act.
Too much information
Kahneman  highlights that there is a limit to the amount of information that the market can efficiently and effectively digest – within a given time scale. This problem is aggregated by having multiple committee members all under the same scrutiny but failing to all sing from the same hymn sheet.
If the central bank attempts to be too communicative, they can counterintuitively crowd out their true message. Alternatively, if they attempt to be concise, markets may become unduly wary due to a perceived lack of evidence.
This careful balance being too demanding therefore, it may be better for central banks to avoid it completely and stick to attempting surprise.
Conclusion: Communication in an imperfect world
This discussion has highlighted that Switzerland’s decision to shock the markets has some theoretical defence.
Although forward guidance may have been seen as an optimal approach, this can be only assumed inter-temporally absolute in a hyper-efficient perfect market setting with all the assumptions holding.
In imperfect settings (i.e. reality), it is therefore better to err on the side of caution and discretion. The constant risk of carelessness and misinterpretation continuously heightening the threat of volatility and quash the very intentions of policymakers.
The very impactful nature of the SNB’s news this week further suggests that it was even more important to not drag out the announcement. Although there may be some impact upon the credibility of the bank, the point must be made that the currency peg was never communicated as permanent. That many market participants had assumed that the peg was permanent merely emphasises the threat associated with the methodology.
Bernanke, Ben. 2004. “Fedspeak.” Remarks at the Meetings of the American Economic Association, San Diego, available at: http://www.federalreserve.gov/boarddocs/speeches/2004/200401032/default.htm.
Blinder, A. S., Ehrmann, M., Fratzscher, M., De Haan, J., & Jansen, D. J. (2008). Central bank communication and monetary policy: A survey of theory and evidence (No. w13932). National Bureau of Economic Research.
Cukierman, Alex, and Allan Meltzer. 1986. “A Theory of Ambiguity, Credibility and Inflation under Discretion and Asymmetric Information.” Econometrica, 54(4): 1099- 1128.
Kahnemann, Daniel. 2003. “Maps of Bounded Rationality: Psychology for Behavioral Economics.” American Economic Review, 93(5): 1449-75.
Elena Logutenkova and Jeffrey Vögel, 2014, http://www.bloomberg.com/news/2015-01-20/swiss-turmoil-spreading-in-europe-as-saxo-credit-suisse-hurt.html
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