Benoît Coeuré: Forward guidance and policy normalisation
Speech by Mr Benoît Coeuré, Member of the Executive Board of the European Central Bank, at
the Deutsches Institut für Wirtschaftsforschung (The German Institute for Economic Research),
Berlin, 17 September 2018.
* * *
Forward guidance has become a valuable and effective policy instrument in central banking over
recent years. There is by now compelling international evidence confirming that forward guidance
has been successful in boosting growth and inflation outcomes by steering future interest rate
1
expectations while central banks have been constrained in their policy space.
More recently, some central banks, including the ECB, have also started to use forward guidance
when heralding the transition out of a phase characterised predominantly by the use of
nonstandard monetary policy measures. In my remarks this morning I would like to explain why the
need for policymakers to enhance transparency increases at times when past policy regularities
2
may offer less guidance, or when the inflation outlook is surrounded by exceptional uncertainty.
In these circumstances, forward guidance may not only be helpful, but also highly effective in
reducing unwarranted uncertainty. I will show evidence that this claim holds true for the
enhanced forward guidance that the ECB's Governing Council delivered at its June monetary
policy meeting.
In the future, there might be a case for the Governing Council to extend its current forward
guidance beyond the timing to lift-off. If warranted, I will argue that this should be done by further
clarifying policymakers' reaction function rather than publishing a numerical forecast of the future
path of short-term interest rates.
Forward guidance on the timing to interest rate lift-off
Let me start with a simple observation.
On my first slide you can see the textbook case for the need of a central bank to embark on
unconventional policy measures. The usual caveats aside, until recently the prescriptions of
simple Taylor-type policy rules have systematically been below actual short-term money market
3
rates.
To fill this policy void, in July 2013 the ECB started to use state-contingent forward guidance that
has contributed to reducing both interest rates, including at longer tenors, and the sensitivity of
money market rates to macroeconomic and political news. This eased financial conditions and
insulated them from external shocks that would have otherwise resulted in an unwarranted
4
tightening.
Starting in June 2014, forward guidance has been complemented by a series of credit easing
measures that have also entailed large-scale asset purchases and the adoption of negative
interest rates. Empirical evidence confirms that these measures have jointly provided substantial
additional policy accommodation that has been instrumental in securing a return of inflation to
5
levels closer to 2%.
What my first slide also suggests, however, is that recently - judging from these simple rule
prescriptions - the policy gap has vanished as the growth and inflation outlook has improved. In
fact, there is now a striking consistency between simple Taylor-type policy rule estimates and the
actual level of money market rates, both current and projected. In other words, one may
conclude from this chart that there is no longer a need for policymakers to resort to forward
guidance as a means to provide the monetary stimulus that would be consistent with simple
benchmark prescriptions.
Of course, central banks do not follow simple policy rules in practice. But the chart nevertheless
raises the legitimate question of why the Governing Council, at its June monetary policy meeting,
decided to be more explicit about its expectations for the timing to interest rate lift-off. After all, in
the past major central banks typically did not issue any specific guidance on the timing and pace
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of future rate hikes.
As you will certainly remember, during past upswings ECB guidance was limited to signposting
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and to the use of a few key words in the introductory statement to the press conference.
Central banks rather signalled future policy intentions implicitly, by revealing information other
than the future policy path - most notably, information about the economic outlook and the
broader monetary policy strategy, including an arithmetic definition of price stability that could
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serve as a long-term nominal anchor for the economy.
This approach to communication and transparency reflected the risks inherent in any type of
explicit forward guidance: that such guidance could crowd out the important diversity of market
views, thereby aggravating the risks of herding, and that it could potentially be taken by outsiders
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as an unconditional commitment.
Our experience with forward guidance has at times confirmed this risk, although its benefits have
by far exceeded its costs. Too often, academics and market participants have interpreted
forward guidance as Odyssean, while for policymakers it can only be Delphic.
The case for the ECB's enhanced forward guidance
Why then didn't the Governing Council decide, in June 2018, to simply return to the well-tested
pre-crisis framework of managing expectations when there was no longer a need to provide
additional policy accommodation? Here it is useful to first consider the market environment we
were facing during the first half of this year and up until the 13 June Governing Council meeting.
You can see this on my second slide.
What you can see here is that, compared to a year earlier, uncertainty around the future path of
short-term interest rates had increased measurably. In the first months of this year, markets
believed that an unusually wide range of policy outcomes would be possible in 2019.
A dispersion of views is not in itself a bad thing, of course. It is usually an encouraging sign that
markets remain attentive to changes in the outlook. The information-processing role of markets
can in fact be expected to recover during periods of policy normalisation. Herding, by contrast, is
often a sign of perilous complacency.
A dispersion of views does become a source of concern, however, if it reflects uncertainty
around the central bank's reaction function. Such uncertainty is not unusual in periods of
transition. Once policy has succeeded in shifting upwards the distribution of risks around the
growth and inflation outlook, uncertainty about the future path of interest rates naturally begins to
increase.
I would argue, however, that our environment is characterised by two factors that vindicate the
need for stronger forward guidance and that have contributed to amplifying uncertainty around
our near-term policy intentions.
The first has to do with the peculiar anatomy of the inflation process we are currently facing.
Although uncertainty around the inflation outlook is receding and a sustained convergence of
inflation to levels closer to our aim is in sight, underlying inflationary pressures have long proven
stubbornly weak - to an extent that, in the past, threatened to destabilise public confidence in the
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return of inflation to levels closer to 2%.
In addition, there is still considerable uncertainty as to whether the key parameters underlying our
workhorse Phillips curve models have undergone structural change - whether inflation has
become less responsive to economic slack, be it through globalisation, technological progress or
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structural product and labour market reforms.
At a time when policy rates remain deeply in negative territory, such parameter and model
uncertainties imply that the costs of committing a type II error - of failing to anticipate a much
slower than usual return of inflation to pre-crisis levels - may be uncomfortably high.
Communicating our expectation that the ECB key interest rates would remain at their present
levels at least through the summer of 2019 was therefore consistent with the "risk management"
approach to monetary policy that the Governing Council has repeatedly applied in recent years,
including in our earlier decisions to clarify our reaction function or to change our policy stance
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pre-emptively in the face of tail risks.
The second factor that has called for more transparency around our policy intentions relates to
the effects of unconventional monetary policy measures. Unwinding policy accommodation in a
multi-dimensional policy space is terra incognita for both financial markets and policymakers.
For this reason, the Governing Council started a long time ago to communicate its expectation
that the key ECB interest rates would remain at their present levels for an extended period of
time, and well past the horizon of our net asset purchases. Transparency about the envisaged
sequence in the adjustment of our various policy instruments was an important element of our
communication strategy.
Yet, on my next slide you can see that, at some point in early 2018, markets expected the ECB to
hike its deposit facility rate one month after the expected end of net asset purchases. Given our
previous indications, and the experience of other central banks, this was an extraordinarily early
expectation, in particular as changes to our key policy rates would have affected the entire term
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structure of interest rates.
In other words, the slide suggests that gradual progress towards a sustained convergence in the
path of inflation increasingly injected volatility into the expected future rate path.
We therefore judged that more clarity on the timing to lift-off could help condense the focus of
market uncertainty from two variables - the end-date of asset purchases and the definition of
"well past" - to one variable - "at least through the summer" - which the Governing Council could
more easily control with its communication.
On my next slide you can see that our enhanced forward guidance has been effective in reducing
uncertainty around the short end of the EONIA forward curve. Shortly after our press conference
on 14 June there has been a notable compression in the option-implied densities around
threemonth EONIA forwards. Dispersion around the median expected path has become much more
condensed.
Guidance on the future path of short-term interest rates
Now, communication about lift-off expectations is, of course, only a first step in managing the
transition towards policy normalisation. A natural question to ask, then, is: should policymakers
also provide guidance on the envisaged subsequent path of future short-term interest rates and,
ultimately, on the expected level of the terminal rate, and if so, how?
There are two broad ways in which central banks can increase transparency around the future
path.
The first is to publish policymakers' projection of the future path of short-term interest rates
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conditional on the macroeconomic outlook.
The second approach is to broadly maintain within the confines of current practice, which is
geared towards explaining in more detail the central bank's reaction function and to communicate
policymakers' conditional expectation of the likely future pace of policy adjustment. The key
difference between the two approaches is, hence, the level of precision with which policymakers
are willing to communicate their future policy inclinations.
The first approach is by no means uncharted territory in the central banking community. A
number of pioneering central banks, led by the Reserve Bank of New Zealand in 1997, regularly
publish numerical interest rate forecasts to reinforce their inflation targeting commitment, very
15
much in line with modern monetary theory.
The experience of these central banks shows that there have been many instances where
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guidance on the future path has been successful in coordinating disperse market views. But
there have also been instances of stark and persistent discrepancies between the path expected
17
by market participants and that published by policymakers.
Some academics have resolved this impasse by arguing that the optimal degree of transparency
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depends on the central bank's ability to forecast the economy. Put simply, transparency
around future policy intentions is likely to be welfare enhancing if the central bank has established
a convincing track record of systematically beating private sector inflation forecasts.
But neither the private sector nor central banks have been particularly good recently at predicting
inflation. More, even a well-established projection track record may not be enough to tilt the
balance in favour of publishing a path for future policy - mainly for four, largely interrelated,
reasons.
First, it is often more important how central banks communicate than what they communicate.
Back in 2004, Alan Blinder already pointed out that a monetary policy committee that releases
dispersed views could cause a "cacophony" in communication and ultimately create more
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confusion than clarity.
Indeed, I believe that one reason why the ECB's enhanced forward guidance has been so
effective is precisely the fact that it represents the Governing Council's unanimous view.
For a large committee to agree on an entire path of future policy rates is, however, a completely
different endeavour and unlikely to be possible in practice, in particular when global uncertainty
20
severely clouds the medium-term outlook.
Incidentally, most market criticism of the Federal Reserve's dot plot focuses on the fact that the
21
dots represent individual views rather than the committee's joint assessment.
Second, even a credible interest rate path may cause misperceptions. Consider the current
market environment that is characterised by regulatory-driven demand for high quality liquid
assets and large securities holdings by central banks.
One tangible consequence of these two factors is an increased demand for safe assets that has
led to substantial and unprecedented negative term premia at the short end of the curve.
This means that the path for rates truly expected by investors is likely to be materially higher than
that suggested by plain forward rates. This greatly complicates the clarity of any guidance on the
future path.
A very simple way to see this is to compare market-based and survey-based expectations. You
can see this on my next slide, where the grey shaded area represents the difference between the
median fed funds rate projections in the New York Fed's Survey of Primary Dealers and the
nominal fed funds futures rates.
Clearly, a good part of the discussion around this gap would vanish if the signals extracted from
market prices were treated more carefully. The chart shows a snapshot of the situation earlier
this year, but the argument holds more widely.
A third source of confusion, specific to the ECB, relates to the policy rate the central bank should
provide a numerical path for.
In the current environment of large excess liquidity the deposit facility rate is de facto our key
policy rate. But charting its future path would be complicated by the endogenous impact of
changes in excess liquidity on its level. At longer tenors in particular, it would be difficult for
markets to disentangle the fraction of the path that reflects a genuine change in policy rates from
that reflecting changes in excess liquidity.
Numerical guidance on our main refinancing rate, by contrast, might be of little value to market
participants at shorter horizons, unless we were to convey, in parallel, information on the
expected width of the rate corridor. In fact, one might even argue that would the Governing
Council decide to publish a path for future interest rates, it would have to anticipate decisions on
the ECB's long-term operational framework, such as whether we intend to retain the pre-crisis
framework of steering short-term rates within an interest rate corridor or whether we plan to
22
adopt a floor system. These are important decisions that need time and careful deliberations.
Finally, it is difficult to communicate about a concept on which the central bank itself has little or
poor information, such as the "terminal rate", or the neutral level of the policy interest rate that is
expected to prevail once all shocks have dissipated.
It is a well-known fact that estimates of the natural rate of interest, commonly referred to as r*,
are highly uncertain no matter which approach is used. For example, the
Holston-LaubachWilliams estimate of the US natural rate could currently be anywhere between -3% and
23
+5%. The same uncertainty applies to estimates of natural rates in other economies, including
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the euro area.
So, all in all, a central bank needs to carefully weigh these risks against the potential benefits of
publishing a numerical forecast of the future policy rate path.
I would argue, however, that the second option I mentioned earlier for providing guidance on the
future path, if warranted, might help overcome many of these risks. That is, rather than
publishing a full numerical interest rate path, policymakers may continue to signal their
inclinations by clarifying their reaction function, even in the period of instrument normalisation.
For example, state-contingent forward guidance could clarify the pace with which policymakers
expect to remove policy accommodation beyond the timing to lift-off. Such guidance can help
improve policy predictability, while avoiding the pitfalls that precise numerical guidance on the
future path of short-term interest rates might entail.
One of the benefits of this type of forward guidance is that it remains a product of the economic
conditions that give rise to it - in other words, it remains Delphic, as it has always been. Should
those conditions change, policymakers may reformulate or repeal the guidance altogether.
Forward guidance linked to specific economic regimes - "Aesopian" forward guidance as it has
25
recently been dubbed - has also been found to be more effective. Empirical evidence
suggests that the public tends to pay more attention to policy signals in unusual economic
26
circumstances than during normal times.
This is certainly our experience with forward guidance in the current uncertain environment but it
also suggests that, in the future, given the complexity of chartering a multidimensional policy
space, a further clarification of our reaction function might help market participants and the
broader public to better anticipate the likely future path of short-term interest rates.
Conclusion
Let me conclude.
Empirical evidence demonstrates that the enhanced forward guidance that the Governing
Council adopted in June 2018 has been effective in reducing uncertainty around the expected
future path of short-term interest rates. It has helped to preserve the current accommodative
financial conditions on which the sustained convergence of inflation to levels that are below, but
close to, 2% over the medium term is based.
Looking ahead, should economic conditions warrant, there might be a case for the Governing
Council to go beyond the timing to lift-off in further clarifying the pace at which it expects to
remove policy accommodation. In the euro area context, I believe that the risks of publishing a
precise numerical forecast of the future path of policy rates are, however, likely to outweigh the
benefits.
Thank you.
Today's remarks focus on rate forward guidance and abstract from forward guidance on the future size and
composition of the central bank's balance sheet.
3
Simple estimated policy rules suffer from two important caveats. First, they do not capture the two-way feedback
between monetary policy and the economy. Second, they are predicated on pre-crisis constant natural rates of
interest, while empirical analyses indicate that the natural rate is likely to have declined since then.
4
See Coeuré, B. (2017), "Central bank communication in a low interest rate environment", Open Economies
Review, Vol. 28, Issue 5, pp. 813-822; and European Central Bank (2014), "The ECB's forward guidance",
Monthly Bulletin, April.
5
See e.g. Altavilla, C., G. Carboni and R. Motto (2015), "Asset purchase programmes and financial markets:
lessons from the euro area", ECB Working Paper No 1864; Andrade, P., J. Breckenfelder, F. De Fiore, P. Karadi
and O. Tristani (2016), "The ECB's asset purchase programme: an early assessment", ECB Working Paper No
1956; and Blattner, T.S. and M. Joyce (2016), "Net debt supply shocks in the euro area and the implications for
QE", ECB Working Papers, No 1957.
6
A notable exception was the Federal Reserve's forward guidance introduced in May 2004, to which I will refer
later in my remarks. The Federal Reserve's date-based guidance issued in 2011 was of more "conventional"
nature as it was used in the face of increasing downside risks to the economic outlook. For an overview, see
Moessner, R., D. J. Jansen and J. de Haan (2017), "Communication About Future Policy Rates in Theory and
Practice: A Survey", Journal of Economic Surveys, Vol. 31, Issue 3, pp. 678-711. For date-based guidance, see
Raskin, M. (2013), "The Effects of the Federal Reserve's Date-Based Forward Guidance", Federal Reserve
Board, Finance and Economics Discussion Series, No. 2013-37.
7
Back in 2006, then ECB President Trichet noted that "the ECB does not embark on a particular multi-monthly
pre-commitment on interest rates or on the path of future policy interest rates". See Trichet, J.C. (2006),
"Monetary Policy and Economic Prospects in the Euro Area", speech at the Institute of Economic Affairs
conference on "The State of the Economy: Overcoming Key Challenges to Sustainable Economic Growth",
London, 6 February.
8
See, for example, Blinder, A.S., M. Ehrmann, M. Fratzscher, J. De Haan and D. J. Jansen (2008), "Central Bank
Communication and Monetary Policy: A Survey of Theory and Evidence", Journal of Economic Literature, 46 (4),
pp. 910-45.
9
See Morris, S. and H. S. Shin (2002), "Social Value of Public Information", American Economic Review, 92 (5),
pp. 1521-1534; and Mishkin, F. (2004), "Can Central Bank Transparency Go Too Far?", NBER Working Papers,
No 10829.
10
On a bigger scale, this relates to an issue I have commented upon extensively in recent times: the threat of
hysteresis. See Coeuré, B. (2017), "Scars or scratches? Hysteresis in the euro area", speech at the International
Center for Monetary and Banking Studies, Geneva, 19 May; and Coeuré, B. (2018), "Scars that never were?
Potential output and slack after the crisis", speech at the CEPII 40th Anniversary Conference, Paris, 12 April.
11
See, for example, Dotsey, M., S. Fujita and T. Stark (2017), "Do Phillips Curves Conditionally Help to Forecast
Inflation?," Federal Reserve Bank of Philadelphia Working Papers, No 17-26; and IMF (2017), "Recent wage
dynamics in advanced economies: drivers and implications", IMF World Economic Outlook, October.
12
See Coeuré, B. (2017), "Central banks as risk managers", speech at the 53rd SEACEN Governors' Conference/
High-Level Seminar and the 37th Meeting of the SEACEN Board of Governors, Bangkok, 16 December. See also
Powell, J.H. (2018), "Monetary Policy in a Changing Economy", speech at the symposium "Changing Market
Structure and Implications for Monetary Policy", sponsored by the Federal Reserve Bank of Kansas City,
Jackson Hole, Wyoming, August 24; and Greenspan, A. (2004), "Risk and Uncertainty in Monetary Policy",
speech at the Meetings of the American Economic Association, San Diego, California, 3 January.
13
One reason for the formation of such expectations might have related to the growing appreciation of the strength
of the stock effect of central bank asset purchase programmes. See Coeuré, B. (2018), "The persistence and
signalling power of central bank asset purchase programmes", speech at the 2018 US Monetary Policy Forum,
New York City, 23 February.
14
This could be done with or without confidence bands signalling the uncertainty around the central projection.
15
See, for example, Woodford, M. (2003), Interest and Prices: Foundations of a Theory of Monetary Policy,
Princeton University Press. The Reserve Bank of New Zealand was followed by the Norges Bank in 2005 and
the Sveriges Riksbank and the Bank of Israel in 2007, and a few others thereafter.
16
See, for example, Bongard et al. (2016), "Connecting the dots: market reactions to forecasts of policy rates and
forward guidance provided by the Fed", DNB Working Papers, No 523; and Brubakk, L., S. ter Ellen and H. Xu
(2017), "Forward guidance through interest rate projections: does it work?", Norges Bank Working Papers, No
62017.
17
The case of the Riksbank in 2011 is probably the most prominent example in this respect. See Svensson, L.E.O
(2014), "Forward Guidance", NBER Working Papers, No 20796.
18
See, for example, Walsh, C. E. (2007), "Optimal Economic Transparency", International Journal of Central
Banking 3 (1), 5-36.
19
See Blinder, A. S. (2004), The Quiet Revolution in Central Banking Goes Modern, Yale University Press.
20
For the difficulties of committees in agreeing on a path of future interest rates, see also Blinder, A., C. Goodhart,
P. Hildebrand, D. Lipton and C. Wyplosz (2003), "How Do Central Banks Talk?", Geneva Reports on the World
Economy, No 3.
21
See, for example, Olson, P. and D. Wessel (2016), Improving The Fed's Dots, The Brookings Institution.
22
See Coeuré, B. (2016), "The ECB's operational framework in post-crisis times", speech at the Federal Reserve
Bank of Kansas City's 40th Economic Policy Symposium, Jackson Hole, 27 August.
23
See Fiorentini, G., A. Galesi, G. Pérez-Quirós and E. Sentana (2018), "The Rise and Fall of the Natural Interest
Rate", Banco de España Working Papers, No 1822.
24
See Fries et al. (2017), "National natural rates of interest and the single monetary policy in the Euro Area",
Banque de France Working Papers, No 611.
25
See Moessner et al. (2017, op. cit.).
26
See, for example, Nimark, K. P. (2014), "Man-bites-dog business cycles", American Economic Review 104(8):
2320-2367; and Woodford, M. (2005), "Central-bank communication and policy effectiveness", paper presented
at the FRB Kansas City Symposium on "The Greenspan Era: Lessons for the Future," Jackson Hole, WY, August
25-27.