Central bankers, who once made cryptic rhetoric central to their jobs, are trying to wean markets off the predictability of forward guidance they cultivated over the past 15 years and return to an era in which starts, stops and occasional surprises in rate hikes are more the norm.
The change is being driven by a recognition that the current battle against inflation may require higher and more frequent adjustments in interest rates than has been the case since 2007, when the U.S. financial crisis ushered in an era of strong and detailed guidance from central banks. This period has seen major upheavals, including the near collapse of the eurozone, weak global growth, plunging oil prices, pandemics and geopolitical conflicts.
Federal Reserve Chairman Powell said at a forum last month:
“Communication carries with it costs for misunderstandings and it can also limit flexibility, so the policy process can either be well understood or not. The policy outlook is so dependent on uncertain future conditions that we have few constructive predictions about the future, so forward guidance should be used with caution.”
The Fed is at such a moment today, as it continues to struggle to tame the worst inflation in 40 years and needs to push its policy rate to a level that will have a restrictive effect, but policymakers are unsure where that level might be or how the economy will respond.
Forward-looking guidance is sometimes effective and sometimes not.
Last week, the Reserve Bank of Australia and the Bank of Canada demonstrated a new policy paradigm by resuming rate hikes with little advance guidance of public expectations after inflation proved more persistent than expected. Both central banks had held rates steady for a while since earlier this year.
The BoE scrapped its explicit guidance in February and tied its decisions to inflation data. As prices continued to climb, investors duly priced in more rate hikes, and with the outlook so uncertain, BoE Governor Andrew Bailey simply avoided pushing them in the other direction.
By contrast, the Bank of Japan, which is still struggling to lift chronically weak inflation, left the core of its guidance unchanged, promising to “patiently” maintain accommodative policy. Still, in a small but important shift, the central bank softened its pledge to keep various interest rates at “current or lower levels.”
The ECB said it had taken a "meeting-by-meeting" approach to interest rates and "strongly opposed resuming direct forward guidance on the policy rate." But in practice, officials provided strong guidance (known as a "directional bias"). This led the market to price in a near 100% chance of a rate hike at the June 15 meeting. Some individual policymakers also said a rate hike should also be expected in July.
Meanwhile, the Federal Reserve faces a tricky decision-making dilemma at its meeting this week.
Although Powell warned in May that the strongest forward guidance is useless when officials are less certain about the outlook, he will still have to issue quarterly projections at his June 13-14 meeting, including a forecast for where the federal funds rate will be at year-end.
The Fed’s dot plot is harder to understand
The so-called dot plot is a transparency tool used by central banks to show officials’ views on the potential development of the economy and is often interpreted as a guide to interest rates.
Former Fed Chairman Ben Bernanke said such tools are “not ideal” for policymakers who don’t want to tie themselves down. “People don’t always understand the difference between commitments and forecasts,” he said at a forum with Powell last month.
If forecasts show policy rates continuing to rise later this year, markets could question officials’ intent to keep rates unchanged at their June meeting, as planned. If rate expectations don’t rise, their lack of reaction to recent data showing strong inflation would also raise questions.
"Walking the tightrope is not easy," said Gregory Daco, chief economist at EY-Parthenon. "Waiting will cause some cognitive dissonance issues. If necessary now, policy should be tightened."
This cognitive dissonance could become more prevalent if investors and analysts become embroiled in a “will there be a rate hike?” debate before every Fed meeting, as they do now.
But this is not necessarily a bad thing and could instead mark a return to normal patterns.
St. Louis Fed President James Bullard said earlier this year that the current tightening cycle is “a return to some degree of normalization of monetary policy, raising or lowering rates as appropriate based on the data, more like we did in the 1990s,” when central bank communication was more constrained.
