Central banks' 'forward guidance' proving a tricky policy tool

Wed Mar 16, 2016 4:12pm EDT
 
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By Balazs Koranyi

FRANKFURT (Reuters) - Words don't always come easy for the world's central bankers, as Mario Draghi was reminded last week.

After first wowing markets at his March 10 news conference with a bigger-than-expected easing package, the European Central Bank president then muddled the message with a seemingly offhand remark that rates may have bottomed out.

Markets eventually calmed, but the reaction to his comment was the latest illustration of how central banks' communications, in particular "forward guidance", can go wrong, and explains why some are already backing away from this relatively new tool.

Central banks have long depended on communication to guide or warn markets: note former Federal Reserve Chairman Alan Greenspan's warning about "irrational exuberance" to express caution about the dot-com bubble or Draghi's promise in 2012 to do "whatever it takes" to preserve the euro.

But forward guidance can be an especially powerful tool because it signals policy intent, sometimes years into the future, reassuring or warning households and corporations about the future path of interest rates.

The result is a nuanced form of communication that can have an immediate positive effect on markets but also easily lead to more confusion than clarity and possibly misfire altogether.

"It's not a promise, it's a best guess. It can't be too detailed and it can't be a promise. In the worst case it can be confusing," said Anatoli Annenkov, an economist at Societe Generale.

For the ECB, the difficulty around last week's meeting may also signal bigger issues with managing expectations, several insiders told Reuters.   Continued...

 
The European Central Bank (ECB) President Mario Draghi addresses a news conference at the ECB headquarters in Frankfurt, Germany, January 21, 2016. REUTERS/Kai Pfaffenbach