Forward Misguidance

FORWARD MISGUIDANCE Dario Perkins

◼ Kevin Warsh wants a new monetary regime without forward guidance; others agree ◼ That’s fine but it’s important not to undermine the accountability of central banks ◼ The implications: more short-term volatility (and maybe less longer-term volatility) Kevin Warsh’s refusal to give forward guidance – on a very broad definition of forward guidance that undermines the central bank’s transparency – has reignited an old debate about how a central bank should communicate with financial markets. Should it signal its policy intentions in advance or let investors figure out its next move on their own? And if the authorities stop offering hints and forecasts about the future, how might that affect asset prices today? The consensus on “best practice” has shifted significantly over time, alongside views about central bank independence and accountability. One thing is clear: short-term market volatility is set to rise, particularly as we transition to a new regime of more extreme supply shocks, against a background of more fractious geopolitics. But if Kevin Warsh and his supporters are correct, more uncertainty about monetary policy could also be a good thing for longer-term financial stability. On a charitable interpretation of these reforms, maybe there is a hint of Minsky to them.

Chart 1: Did Bernanke take Fed transparency too far? Warsh thinks so 13 Fed transparancy index (maximum is 15) 12 2012: Bernanke reforms 11 (press conference, formal 2% target, dots, etc) 10

9 2008: Summary of Economic Projections (first Bernanke reform) 2005: earlier minutes 8 2002: vote tallies disclosed 7 1999: immediate bias disclosure

Source: Dincer-Eichengreen index of central bank transparency

The importance of accountability We should be clear from the start that central bank accountability is vital in a modern, well- functioning democracy. Kevin Warsh is one of the most powerful people on the planet; and if he makes mistakes, they could cost millions of people their jobs. Yet nobody elected him. Thirty years ago, the prospect of unelected technocrats wielding such power left many commentators feeling queasy. Central bank independence is a relatively modern idea; and back then, opinion was

more evenly divided about whether it was a good thing. If you sat an economics exam in the 1990s, you were expected to provide a detailed list of both the advantages and disadvantages of putting monetary policy into the hands of unelected mandarins. The debate was eventually settled with a compromise: a committee of technocrats were allowed to set interest rates only on the condition that they regularly explained their actions – both to Congress and to the households and businesses they were expected to serve. We demanded transparency. Based on his first two press conferences as chair, this is a principle that Kevin Warsh has seemingly forgotten. It’s one thing not to offer hints and nudges about future interest rates; it’s another to refuse to answer basic questions about the past or the present. His last press conference, reduced to 45 minutes of soundbites, was particularly poor for Fed transparency. And markets clearly didn’t like it – for good reason. Not only is a Warsh a rookie when it comes to chairing the Fed, but he was appointed under unusual circumstances, amid serious concerns about Trumpian politicization of the central bank. Forty-five minutes of “everything is great” and “trust me, bro” won’t cut it.

Chart 2: Independence increased from the 1990s Chart 3: Independence tamed inflation? CB independence score

UK US GER CAN AUS SWE NZL JPN OECD inflation CB independence (RHS)

Source: Romelli index of central bank independence Source: Romelli, OECD

Forward guidance vs transparency You often hear Fed watchers say they don’t need forward guidance; they just want to understand the central bank’s “reaction function”. Warsh himself endorsed this line of thinking in 2014, when he reviewed Bank of England communication. But the distinction can be fuzzy – and Warsh adopted a very different, more sceptical view at his latest press conference (funny how that happens…). In principle, forward guidance is telling markets what you’re…