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Reliable partners speech
by Ben Broadbent
Given at Gresham College, London
Published on 30 March 2022
The Bank of England's Monetary Policy Committee (MPC) was set up 25 years
ago to use monetary policy to keep the rate of inflation in the UK low and
stable. Ben Broadbent talks about its work.
Ben focuses on some of the theory, the practice and the pitfalls of
communication about the course of monetary policy over the future
(sometimes called "forward guidance"). He stresses the importance of
understanding that the path of policy will depend on how the outlook for the
economy evolves.
Speech
Good morning. It's a pleasure to be here at Gresham College, a place that has held public
lectures on important societal questions for over four hundred years. That makes it one of the
few City institutions that's been around longer than the Bank of England. I would also like to
thank both NIESR and the Money, Macro and Finance Society (MMF) for organising the
event. Over the years the work of both institutions has been invaluable to the UK policy
community.
We are living through the most extraordinary - and in many ways an extraordinarily
unwelcome - time. Russia's unprovoked attack on Ukraine has brought war to Europe for the
first time in decades, with all its terrible humanitarian consequences.
From an economic perspective, coming on top of what was already a very steep rise in the
cost of globally traded goods, in the wake of the pandemic, the invasion has led to substantial
rises in the cost of energy and other commodities. As a big net importer of manufactures and
commodities it's doubtful that the UK has ever experienced an external hit to real national
income on this scale. From the narrow perspective of monetary policy it will result in the near
term in the difficult combination of even higher inflation but weaker domestic demand and
output growth.
However, the MPC has already said quite a bit about these things, individually and
collectively, and - dramatic though its economic effects have been - my topic today is not this
awful conflict or the immediate questions it poses monetary policy. I've no doubt we will
discuss these things in the Q&A. Instead, I wanted to talk about something more general,
namely the communication of monetary policy, and specifically the role of "forward guidance".
I will take this to mean statements by monetary authorities about future policy.
The question "what's going to happen to interest rates?" is asked of us routinely. (Sometimes
it's phrased directly, sometimes more circuitously, but it always seems to come in one form or
another.) And perhaps it's understandable that people should want to know, particularly in an
environment as uncertain as this. If it were possible to eliminate or reduce at least one source
of unpredictability, wouldn't that be a good thing? And since the MPC is in control of interest
rates why can't it just tell us what it's going to do?
The problem is that we can't be sure. Interest rates are not an end in themselves. They're a
means of meeting our objectives: the stabilisation of inflation over the medium term and,
subject to that, the stabilisation of economic activity. And because there are lots of
unpredictable shocks hitting the economy, things that would otherwise (and often do) move
output and inflation around, the appropriate path of interest rates is necessarily unpredictable
as well. The skipper of a boat, adapting to a skittish wind, and interested in making the
journey as smooth as possible, may have perfect control of the tiller. But that doesn't mean
she can tell you exactly which position it will be in at every point in the future. That will depend
on the direction of the wind at the time.
It's not that monetary authorities are unconcerned about expectations of future interest rates.
Quite the opposite: these expectations are central to the transmission of policy. We directly
determine only one particular - and very short-term - interest rate (what commercial banks
get paid on their overnight deposits, or "reserves", at the central bank). But demand and
spending depend more on longer-term interest rates. In the UK, around half of corporate
borrowing has a maturity of three years or more. Some mortgages have interest costs tied
directly to Bank Rate but most are now fixed for at least two years. And these longer-term
rates depend in their turn on expectations of how the short-term interest rate evolves over the
future. So they matter.
Equally, however, these expectations should - and generally do - respond to the news about
the economy of their own accord, without the need for any explicit prompting by the central
bank. The private sector forms its own views about how the economy might evolve over the
future, views that are continually adjusted as new information comes in. As long as people
also understand the objectives of the central bank, and therefore the appropriate response of
policy, they should then be able to work out for themselves what that news means for the
likely path of interest rates.
Sometimes, when economic conditions are relatively stable, there isn't that much to work out,
as one can observe the central bank's "reaction function" - how it responds to incoming data
- pretty much directly. In the years prior to the financial crisis, official interest rates in the UK
were very tightly correlated with economic activity (and exhibited very little dependence on
anything else). Chart 1 is one way of representing that relationship: it plots the change in the
average interest-rate vote on the MPC, in basis points, against a survey-based measure of
economic growth[1]. At least until 2008 the correspondence was extremely tight.
Chart 1: Monetary policy and economic activity tightly correlated before the financial
crisis
Six-month rolling averages. Combined IHS Markit/CIPS and CBI distributive trades lagged one month. Sources: ONS, IHS
Markit/CIPS, CBI, Bank of England and Bank calculations.
From an economic perspective, the behaviour of policy over that period was understandable.
If you think trend supply growth is pretty stable - and that was generally the view at the time -
then stronger activity will always mean more pressure on resources, weaker activity less of it.
So, in order to stabilise inflation, your best response is to lean against these swings in
demand. If, in addition, there are few other enduring influences on inflation (from the rest of
the world, for example) then there's no reason to respond to anything else.
Whatever the rationale, this stable "reaction function" made it easier for asset prices to
respond as well, in a similar fashion. Chart 2 plots that same survey-based measure of
economic growth against expected future interest rates (specifically the three-year forward
rate). Even without any verbal encouragement from the MPC monetary conditions tightened in
response to stronger growth. As Mervyn King pointed out at the time, the cyclicality of forward
interest rates, in anticipation of action by the MPC, itself helped to stabilise demand, putting
less burden on the policy rate. (Some of you may remember that, in an unlikely comparison,
he suggested this was similar to the behaviour of the hapless England defenders against the
great Diego Maradona in the 1986 World Cup. This was the first, and I daresay the last, time
that MPC members were likened to an elite sportsman.)[2]
Chart 2: Forward interest rates and economic activity also co-moved closely before
the financial crisis, less so afterwards
Six-month rolling averages. Combined IHS Markit/CIPS and CBI distributive trades lagged one month.
Six-month change in one-year forward one-year LIBOR rate, spliced onto one-year, one-year OIS rate in 2022. Sources:
ONS, IHS Markit/CIPS, CBI, Bloomberg Finance L.P. and Bank calculations.
So if financial markets are able to react this way, without any explicit hints from the policy
maker, why has there since been more communication from central banks about future policy
- and more expectation of it in financial markets? What is the rationale for "forward
guidance"?
At least in theory there are two distinct types of guidance. The reasons for both, I think, are
connected with changes in the economy in recent years. But they are quite distinct and it's
important to understand how.
The first - sometimes described in the economics literature (somewhat grandiosely) as
"Delphic" guidance - seeks in general to convey what is sometimes referred to as "private
information" held by the central bank. This makes it sound more exciting than it really is. More
often than not it means making clear to the outside world the policy maker's view of how the
economy might evolve over the future - its forecasts - and to clarify the so-called "reaction
function" (how monetary policy might respond to possible future events).
I said the simple pre-crisis pattern in Chart 1 was the appropriate way to set interest rates if
you're in an environment where swings in economic growth are driven predominantly by
shocks to demand, things that push output and inflation in the same direction, and if there are
few other enduring shocks to inflation.
But if that was a reasonable view of the world in the years before the financial crisis - a period
some now call the "the Great Moderation" - it's clearly been much less of one since.
Productivity growth is less predictable and it's harder to count on a single rate of "trend
growth". (Nor can we be assured of a fixed, "neutral" rate of interest, below which policy is
necessarily expansionary and contractionary only above it. In particular, it became clear even
before the crisis, and increasingly so after it, that this "neutral rate" had over many years been
declining.) And if we'd forgotten during the Great Moderation that domestic output isn't the
only thing that affects inflation we've certainly been reminded of it since. In the UK, the two big
exchange-rate depreciations in 2008 and 2016 pushed up inflation for a protracted period,
independently of activity at home. The strains in global goods markets caused by the
pandemic, and the substantial impact on commodity prices of Russia's invasion of Ukraine,
have done the same, to an even greater extent. In this environment, simple rules of thumb like
Chart 1 are less reliable - you can see clearly how the correlation between the two lines
declined after the crisis - and it might therefore be an advantage for the central bank to
communicate more about how policy is being set.
This "Delphic" guidance can come in various forms. Regular forecasts are part of it. You can
speak directly about the changing environment and the implications for the reaction function,
perhaps with the aid of particular simulations (I gave a talk in 2013 arguing that, when
productivity growth is less predictable, the monetary authority will want to put less weight on
output and more on the domestic labour market[3]). Monetary authorities have often made
more specific remarks about the near-term path of interest rates, depending on how things
turn out ("if the economy develops in line with our forecast then policy might be expected to
do such-and-such" is a typical example). A handful of central banks publish forecasts of the
policy rate, alongside those for GDP and inflation. Their joint behaviour can help people
understand how these things interact.
It's worth noting up front that not all forms of "Delphic" guidance have to involve direct
communication about the future path of interest rates. And, whatever its precise form, the
important point about this sort of guidance is that it's always conditional. These are - and
should always be seen as - "if....then" statements. Their purpose is not to pledge some
particular path of policy, independently of what happens to the economy. It's to help people
understand the dependence of policy on the economic outlook.
The other form of guidance - sometimes called "Odyssean" - is quite different in this respect.
It actively promises a certain path - in particular to keep interest rates very low - almost
regardless of how things turn out. It's a means of easing monetary conditions, and specifically
of lowering longer-term real interest rates, when the outlook for inflation is weak but the
immediate policy rate is constrained by the lower bound (and if other alternatives like QE are
for some reason unavailable or ineffective). If you're able to convince people that, even in the
event of a positive shock to inflation in the future, you won't raise interest rates, this can push
up expected inflation, thereby reducing the real forward rate of interest and encouraging more
demand today.
This "promise to be irresponsible"[4] won't necessarily be believed because, when the time
comes, and if there were subsequently some significant rise in inflationary pressure, the
policymaker will be tempted to go back on the earlier promise and respond by raising interest
rates. The optimal policy is intrinsically "time inconsistent". But if you can find a way of tying
yourself to the policy in advance - like Odysseus lashing himself to the mast of his ship - then
this is in principle an effective way of easing monetary conditions, even when the policy rate
itself can't be lowered any further.
It's striking that this "Odyssean" guidance has received much more attention in the economics
literature - but, in the real world, and despite often being right up against the lower bound,
central banks have used it only rarely. This may be because, in practice, it's quite difficult to
make credible commitments of this sort (and because central banks have also been able to
use QE). Whatever the reason, most "forward guidance" has been of the "Delphic", more
conditional form.
Yet my impression is that outside observers can sometimes mistake one for the other: the "if"
clause is forgotten, or downplayed, and purely conditional statements somehow get
interpreted (or rather misinterpreted) as hard commitments.
It's not entirely clear why this is the case. It may be quite a deep-seated tendency. Some
psychological research demonstrates that people can misconstrue "if...then" statements,
particularly if they're fairly abstract. It may also be wishful: because people don't like
uncertainty and would therefore prefer there to be some fixed path of interest rates set in
advance, perhaps they're prone to believe that this is what they're being told.
But there's no doubt it happens. In September 2013, the MPC said that a minimum necessary
condition for a rise in interest rates was that unemployment should fall below 7%. This was
not a sufficient condition and the Committee was also at pains to emphasise that the actual
path of rates would depend on the outlook for the economy at the time. Yet quite a few
observers viewed the condition as a hard trigger and were confused when rates didn't
immediately and automatically rise in response (memorably, one MP subsequently likened the
Committee to "an unreliable boyfriend, blowing hot and cold").
Similarly, in a speech in July 2015[5], the then-Governor Mark Carney said the "the decision
as to when to [start raising interest rates] will likely come into sharper relief around the turn of
the year". This was no more than suggestive and was immediately qualified with a remark
about the importance of economic developments in the interim: "I am conscious of several
important considerations which mean the actual path [of interest rates] almost certainly will
not be mechanical, linear or pre-determined. First and foremost, shocks to the economy could
easily adjust the timing and magnitude of interest rate increases....There is, in fact, a wide
distribution of possible outcomes around any expected path for Bank Rate, reflecting the
inevitability that the economy will be buffeted by shocks and that monetary policy will have to
adjust accordingly." Yet when - thanks precisely to such shocks - interest rates did not
subsequently rise "around the turn of the year", he was criticised for having misled people.
Such criticisms, whether justified or not, are par for the course, and may not be that
consequential in the grand scheme of things. But there could be a more material cost if, in
mistaking conditional for unconditional statements, people come to rely on them at the
expense of thinking about the economy, and its implications for interest rates, for themselves.
As I said earlier, it's an important part of the transmission of policy, and of the stability of
demand more generally, that prices in financial markets respond to economic news as it
comes in, without the need for any prompting by the central bank. That is precisely the
purpose of the "Delphic" sort of guidance that, in the main, central banks have employed. But
as Chart 3 demonstrates, the sensitivity of market interest rates to releases of economic data
seems to have declined somewhat in recent years.
Chart 3: The sensitivity of market interest rates to news in economic data has fallen in
recent years
Sensitivity of 3-year spot rates to economic data news: coefficient in regressions of change in the interest rate to change in a
data surprise index prepared by Bank staff, using 12-month rolling windows.
Sources: Bloomberg Finance L.P., Refinitive Datascope and Bank calculations.
There could, of course, be several explanations for this. It may well be that, precisely because
the economy seems less predictable than it was during the "Great Moderation", markets are
understandably more reluctant to infer things about the medium term from shorter-term data.
The fact that central banks have for so long been pressed up against the lower bound would
also naturally have attenuated the reaction of forward rates to news about the economy (they
can't fall as far as they usually would in response to negative news). But it's possible that an
over-reliance on central bank communication, and a misinterpretation of it as a fixed plan for
interest rates, has contributed to this as well. If you believe that the monetary authority will
always tell you in advance what it's going to do you may feel less inclined to anticipate and
price such a response yourself[6].
I don't know if this is true. It's really no more than a conjecture, and a relatively idle one at
that. But it would be an irony if an effort to get people to think more about how monetary
policy might respond to events, by communicating something akin to a "reaction function", had
actually had the opposite effect.
At any rate, having already gone through at some length the point I want to make, the rest just
fills in some gaps. I'll start with a more formal description of "Odyssean" guidance, explaining
why, when the interest rate is up against the lower bound, there could be very significant
gains to credible commitments to keep rates low in future - but also why, in practice, such
credibility is hard to secure.
There's then a brief discussion at various forms of guidance in the real world. As we'll see, the
distinction between "Odyssean" and "Delphic" guidance is less clear in practice than in theory.
In the real world the dividing line between them is sometimes a bit fuzzy. This may have
contributed to the conflation of the two - more exactly the (mis)interpretation of conditional as
unconditional statements - in the outside world. But I think it's clear enough that central banks
have rarely if ever committed themselves unconditionally to future policy.
It's clear too that, on several occasions, the outside world has nonetheless viewed these
statements as promises. I'll give some examples before a short concluding section.
Credible, "low-for-long" guidance as a means of easing policy at
the lower bound
So let's start with the value of commitment when the policy rate is close to the lower bound.
As you know, the last thirty years have seen a marked decline, around the world, in the
underlying, "equilibrium" real rate of interest (sometimes called "R*"). This a real
phenomenon, not a monetary one, caused by some combination of a greater desire to save -
across the world as a whole - and weaker investment demand. But central banks have still
had to accommodate the decline and the appropriate nominal rate of interest has therefore
fallen alongside this "R*" [7].
However, there's a limit to how far the nominal rate can fall. As long as people also have
access to physical cash, bearing zero interest, it's not possible to lower the official rate much
below that level. And when the "normal" policy rate is already close to that lower bound
there's very little room for conventional policy to respond to negative, disinflationary shocks.
This in turn creates the potential for deflationary traps. Because the policy rate can't fall in
response, a decline in inflation expectations pushes up real interest rates, depresses demand
and inflation, and this justifies the original (and self-perpetuating) weakness of expectations.
These traps are potentially very costly as they can lead to protracted periods of unnecessarily
weak economic activity. It was in a determined effort to avoid them, having already cut interest
rates as far as they could, that central banks then turned to alternative, "unconventional"
monetary policies. For the most part this meant QE. Asset purchases are designed to keep a
lid on forward rates, thereby supporting demand and activity.
In the academic literature, however, many economists argued for an alternative - and
potentially more powerful - option, namely a committed form of forward guidance. The
economist Michael Woodford has been one prominent advocate[8].
Remember that the name of the game, when faced with this risk, and having run out of room
to cut the policy rate any further, is to lower forward real interest rates. In this respect, a
credible declaration that you will keep the actual policy rate low, even in the event of a future
increase in inflation, does two things. It keeps nominal forward rates low. It also raises
expected inflation. In the normal course of events the central bank would tighten policy as
inflation rises, choking it off before it turns into a persistent overshoot. If you tell people you're
not going to do this then - as long as they believe you - this will push up inflation
expectations and further depress the real rate of interest.
In many simple economic models expected real interest rates have almost as big an effect on
spending as the current real rate. In that setting, credible guidance that depresses those
forward real rates can therefore be an effective way of boosting demand and combatting the
risk of deflation. Chart 4, based on simulations with a simple (and pretty standard) model of
the economy, gets the point across.
Chart 4. The ability to commit credibly to future policy helps soften the effects of the
lower bound
Results from a simulation of a small macroeconomic model under alternative assumptions about monetary policy and the
average distance to the lower bound. Macroeconomic volatility is measured using a simple "loss function" that weights the
variance of inflation and the output gap. The y-axis shows the square root of the loss function, scaled to 1 for the case of
commitment policy with an average distance to the lower bound of 5pp. Sources: See Appendix for further details.
What we've done is to hit this simple model economy[9] with lots of simulated shocks and
measure how far it is, on average, from meeting the central bank's objectives - keeping
inflation close to target and output close to potential. (A simple measure of this, based on a
"loss function" that weights together the variances of the output gap and inflation, is plotted on
the y-axis. Note that the perfect score of zero isn't attainable. Because there are so-called
"trade-off-inducing" shocks in the model, things that push the objectives in different directions,
inflation and demand can't both be perfectly stabilised[10]).
We've plotted this performance while varying two key things. One is the distance between the
"neutral" nominal rate of interest and the lower bound. This is plotted on the x-axis. The larger
this gap (i.e. the further you are to the right) the less the lower bound is likely to matter. There
may occasionally be shocks that are bad enough to take you there but they obviously become
rarer the more distant the average policy rate from its floor. Maybe you can think of this a
reasonable description of the 1990s (when the neutral interest rate was comfortably above
zero and "forward guidance" was no more than a twinkle in Michael Woodford's eye).
The second is the scope for this committed ("Odyssean") form of guidance. QE isn't available
to either of the policymakers in Chart 4. But one, at least, has the capacity to commit credibly
to particular policies beyond the current date. The average loss in this case is plotted in blue.
The red policymaker can't do this. He takes the lower bound into account when setting current
policy, but, unfettered by any sort of prior commitment, he's free to reset policy each period as
he sees fit.
This may sound like a good thing (isn't it better always to have full discretion?) and there are
certainly many instances in which the blue policymaker would prefer to be released from his
earlier promise. But perhaps a better way to think of it is to recognise that, thanks to this
ability to make credible commitments, Blue essentially gets to choose future as well as current
policy. This is a pretty valuable addition to the set of monetary tools when the current interest
rate can't be cut (and if the economy responds sensitively to forward rates).
Without it, as you can see, the simulated performance of the economy deteriorates
significantly as the neutral real interest rate gets closer to the lower bound (i.e. as the red line
approaches the origin). Unable to do much about them, the fully discretionary policymaker will
spend quite a bit of time in these low-inflation, low-output traps. But because he effectively
controls future as well as current policy, and can credibly "promise to be irresponsible" (i.e. to
keep rates low even in the event of positive inflationary shocks in the future), the blue
policymaker manages to avoid the worst effects of the lower bound for interest rates.
Forward guidance in practice
What about the real world? Is it blue or red?
In practice, looking at what central banks have actually said about future policy, the boundary
between the two is less clear in practice than in the theory. Even a fully discretionary
policymaker - one who can't credibly commit to future policy decisions - may react slightly
differently to incoming data around the lower bound. As I pointed out in the introduction, there
may be other changes in the economy (less predictable productivity growth, for example) that
also warrant a change in the "reaction function". So, if a statement signals some shift in how
policy might respond to the economy, that doesn't necessarily make it "Odyssean".
Nor does commitment mean you ignore entirely what's going on in the economy: the blue
policymaker is still "data dependent" in some sense, just less so - less responsive to inflation
overshoots in particular - than the red. So although I've been stressing the contingent nature
of "Delphic" guidance, and the relative invariance in the case of commitment, it's not a rigid
distinction. In any case, perhaps there's always some room for interpretation when it comes to
language.
That said, I think one can still outline some broad parameters - things that colour a statement
more in one shade than another - that can help distinguish the two. For example, Odyssean,
committed guidance is probably more likely to refer to dates - a time-frame for low interest
rates - than to economic conditions alone. If it does tie future policy to economic variables it
may explicitly pick out inflation expectations (as Odyssean guidance is explicitly designed to
raise them). More generally, it will actively seek to convey a more dovish stance relative to
incoming data. Without these things, a statement that simply says "we expect such-and-such
a policy to be appropriate given the current outlook" doesn't seem to me to qualify, especially
if it goes on to stress the dependence of one on the other. The same goes for forecasts of
future interest rates based on the latest projections for the economy. These are just an effort
to explain more about the "reaction function".
On these grounds, and even with a fairly liberal interpretation of these requirements, it's
difficult to pick out many episodes that clearly count as pre-commitment. Perhaps the US
Fed's communications during and in the years after the financial crisis came the closest,
though the shift to more Odyssean-like guidance was as much evolutionary as revolutionary.
The FOMC had begun to signal the likelihood of a long period of low interest rates as early as
December 2008, though to begin with, this was phrased simply as what would be justified by
the economic outlook:
"Weak economic conditions are likely to warrant exceptionally low levels of the federal funds
rate for some time"
The following summer, the statement still explained the outlook for policy as a normal and
justifiable response to that for the economy, but for the first time introduced specific timelines:
"The Committee currently anticipates that economic conditions...are likely to warrant
exceptionally low levels for the federal funds rate at least through mid-2013".
Some years later, by 2012, the FOMC was indicating not only a time horizon for low rates but
had added two important extra ingredients - first, the recognition that policy was "highly
accommodative" and second, that it would remain so even after a fuller economic recovery
had taken hold:
"The Committee expects that a highly accommodative stance of monetary policy will remain
appropriate for a considerable time after the economic recovery strengthens. [It]...currently
anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at
least through mid-2015."
I suppose you could still quibble about how committed this language really is. But the clear
dovish skew puts it more firmly in the Odyssean camp than the earlier statements. This is also
the view of Del Negro and co-authors, in a 2015 paper looking at the effects of this
guidance.[11] In any event, to my mind it's hard to find guidance from other central banks that
has come as close as this. If you squint a bit you could perhaps see some of the same in the
ECB's new strategy, published last autumn. The ECB said that, when rates were close to the
lower bound, policy should respond "forcefully and persistently" and that "This may also imply
a transitory period in which inflation is moderately above target"[12].
But this is about the ECB's general strategy, not a particular path for policy. Even a "red",
discretionary policymaker would in practice recognise that the proximity of the lower bound
can affect appropriate policy. And the ECB took pains to say that, although the approach
might skew the subsequent distribution of possible inflation outcomes to the upside, this
would be "accidental not deliberate". So I don't think it really qualifies.
Anyhow, these episodes aside, most guidance seems to me to be pretty clearly "Delphic" in
nature: it's about the central bank's view of economic outlook (a forecast) and about policy
conditional on it (a "reaction function"). As a general matter, we know that's the purpose of
numerical forecasts for interest rates, because those central banks that publish them tell us
so. The Norwegian central bank, for example, describes the rationale like this: "With the aid of
the policy rate paths and related communication, Norges Bank provides forward guidance
regarding future policy rate developments and information about the central bank's response
[13]
pattern."
As for the UK, the few times the MPC has issued formal guidance about policy, it's very
clearly of this type. If ever it's said something about future policy, it's always been in the
context of, and dependent on, the outlook for the economy and inflation at the time.
In August 2013, the Committee said it would not raise interest rates "at least" until
unemployment had fallen to below 7% (so passing this threshold was a necessary but not a
sufficient condition for a hike). It added the proviso that low rates would be maintained only
"provided this does not entail material risks to either price stability or to financial stability".
My own interpretation was that this guidance helped to signal the greater dependence of
policy on the labour market, at a time of greater uncertainty about supply. Whatever one's
v