Forward misguidance: Unreliable central banks are fuelling market volatility
At the bottom of every financial prediction or statement, often buried under mountains of small print, is a warning that past performance is not necessarily indicative of future results. This is true whether we look at stock markets, investment funds or central banks. Since 2013, however, some of the world’s largest financial institutions have been trying to counter this assertion and to plot a dotted line into the future.
“Forward guidance” has seen some of the world’s most important central banks attempting to provide reassurance about the future course of interest rates. Mark Carney, governor of the Bank of England, has been vocal in his predictions, while providing additional support by publishing economic data and projections.
But why has forward guidance become necessary? In the wake of one of the most severe financial crises ever, central banks have had to step outside the box to deliver unconventional monetary policy responses to the challenges that have arisen. Forward guidance was designed to calm markets and provide some certainty for investors, who might otherwise have looked quizzically at the actions of the Bank of England, the US Federal Reserve, and the European Central Bank (ECB).
For fixed income investors, particularly those employing absolute return strategies, the outlook for interest rates and inflation is paramount. Forward guidance is intended to dampen volatility in markets and act as a stability tool for prices. Indicating a probable path for interest rates should also help to avoid sudden shocks to the financial system and the wider economy.
Yet despite its supposed status as a key tenet of monetary policy, the guidance provided by central banks has proved to be fleeting, inconsistent and, at times, inaccurate.
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Central banks have dashed investors’ expectations time and time again: the Bank of England scrapped the link between interest rate rises and the official unemployment figure, and the ECB, having led the markets to expect a “bazooka” response to the threat of deflation in December 2015, provided instead something more akin to a peashooter. Increasingly, the Bank of Japan, far from providing clear directional statements ahead of action, has kept investors guessing, turning to “shock and awe” tactics; examples include telling investors that negative interest rates were not on the agenda, and then implementing them a week later.
The only central bank to have been slightly more reliable is the Fed. While not delivering precisely what it had promised, its forward guidance over the timing of the first rate hike in nearly a decade did turn out to be fairly consistent with the Federal Open Market Committee’s decision to raise rates in December – just three months later than initially indicated, after a perceived emergence of global risks including an economic slowdown in China.
However, even the Fed could now be accused of misguidance, having changed its messaging from month to month in 2016, while betraying a backward-looking dependence on data that is somewhat at odds with the concept of forward guidance. Having originally indicated four further rate rises for 2016, the challenging start to the year for equity markets, significant declines in oil prices and the perceived downturn in China meant that the Fed subsequently revised its forecasts down to just two. Despite initial doubts about whether June would be selected for the next increase, the Fed now seems to be changing its tune again and is guiding markets to two or three rate rises this year, saying June is a “live” month for a hike.
Central banks do, however, appear to be changing their approach to forward guidance. Many are now adopting the tactics of “under-promising” and “over-delivering” to shock markets into increased confidence in monetary policy, or of caveating heavily any guidance given. The ECB has led the way, actively under-promising in guidance and then over-delivering through the latest extension to its quantitative easing programme. The Fed’s forward guidance now comes qualified by the famous words “data dependent”.
Read more: The sorry tale of forward guidance
But in truth, the whole premise of forward guidance is flawed because central banks have always been reactive, not proactive. Despite their forecasting, they rely ultimately on past performance. In the case of the Bank of England, the focus appears to be on “spot” inflation rather than inflation in the medium to long term, the latter being the remit of the Monetary Policy Committee, which sets the base rate.
Clearly, central bank policy, especially forward guidance, is important for investors, but whether it works as a tool to calm markets remains far from certain. Indeed, we might even argue that the more guidance central banks provide, the more volatile markets could be when past performance turns out not to be reflected in future results.