AUTHOR: JAKUB DRABIK, FREQUENT CONTRIBUTOR, THE LONDON GLOBALIST

Last week, despite calls asking him to step down Mark Carney announced he would remain the governor of the Bank of England (BoE) until the end of June 2019. The criticism came mostly from Eurosceptic MPs who felt the governor compromised the central bank’s political neutrality in the wake of the referendum. Others, however, attacked him over his near zero interest rate policy.

Following the Great Recession of 2007-08, short-term interest rates (base rates) were lowered near the zero lower bound and have stayed there ever since. This led many western central banks to unveil a strategy of “forward guidance”. Ben Bernanke, then chairman of the Federal Reserve (Fed), first announced his plan in December 2012 and Mark Carney soon followed in August 2013. The purpose of this policy was simple; to convince markets that the central bank would not raise its base rate.

Unlike in convention monetary policy, where the central bank can directly stimulate the economy by cutting the base rate, forward guidance aims to do this through its influence on public behaviour. The central bank seeks to eliminate the uncertainty around its future monetary policy by announcing to the public that it will hold the base rate at the zero lower bound until certain conditions are met. In theory, if the announcement is credible, commercial banks will follow by lowering their own interest rates. This is different to a normal base rate cut, which banks may deem to be temporary, leaving them with little incentive to pass the cut onto the consumer. The hopeful end result is of low long term interest rates that boost borrowing and spending in the economy.

This form of forward guidance has come to be known as Odyssian. However, there is another type, subtly different in nature, called Delphic forward guidance. The purpose of Odyssian forward guidance is to convince markets that once the economy recovers the central bank will wait longer than usual until it responds to rising inflation. On the other hand, with Delphic forward guidance the central bank simply publishes forecasts of the base rate it will set. For the rest of this article I will only talk about Odyssian forward guidance, as this is the type newspapers often refer to.

The advantage of forward guidance over other forms of monetary policy is that it is able to change public expectations immediately. This contrasts to an actual change in the base rate, which usually takes one and a half years to filter through the economy, or quantitative easing where the banks may choose to store some of the cash the central bank injected.

The problem with forward guidance, however, is that like most of monetary economics it sounds good in theory but works differently in practice. The first issue that economists often point to, is the central bank’s credibility to commit to a low base rate. When the Fed, or the BoE, see the economy recovering with rising inflation, what stops them from cranking up the interest rate to 20%? Well for one they are not stupid. But also, they do not want to lose the trust of the market, which will prevent them from using the policy again in the future. This is why, despite some “ifs” and “buts” in the past, I do not think commitment is that big of an issue when it comes to a major central bank. Another issue some politicians argue, as mentioned in the opening paragraph, is that forward guidance is used to keep interest rates low for too long. This again, I feel, is an unfair statement, for you should not blame a tool for the job it is supposed to do. After all, would you blame a spade for digging the hole you fell into?

More importantly the issue that I believe is largely understated is of whether the public knows, or even cares, what the future interest rate is going to be. A random person on the street is unlikely to be able to tell you the conditions for a base rate hike let alone the interest rate the commercial bank will charge. As economists I feel we often spend too much time studying the economy and not enough time studying the people that are in it.

For it is often said that forward guidance lives and dies with the central bank’s transparency, but if nobody is paying attention to what the central bank is saying then we have a far greater problem on our hands.