One of the benefits of forward guidance that the MPC is counting on, and has trumpeted, is that it will reduce uncertainty about future interest rates. Lower uncertainty should increase spending as economic agents need to put less aside to see them through potential scenarios for high interest rates, which would mean high cost of servicing mortgages and other debt.
However, the BoE has not made much of the fact that its main economic model (‘COMPASS’), used to evaluate the effects of forward guidance, omits this channel entirely. (In the jargon, the model displays ‘certainty equivalence’). This is not oversight on the Bank’s part. Solving and simulating a model as rich in detail as COMPASS is that did incorporate the effects of changing uncertainty would be extremely difficult and cumbersome. And with current computing speeds it would probably be impossible to estimate such a model to get it to describe UK data well.
The emphasis placed on the reduction in uncertainty in the language describing forward guidance leads us to think that this is a relatively important effect. Since this effect is omitted from the main model, one must presume that the MPC’s own forecast of what it will do with rates (or, equivalently, how long it will take unemployment to fall to 7% at constant rates) incorporates some judgement applied to the forecast to guess at the effect of the missing uncertainty channel. If so, how strong are these effects estimated to be? Where do those estimates come from? One could produce estimates using much simpler models that omit monetary policy entirely (and my hunch would be that changes in interest rate uncertainty of the magnitude that one might hope for through successful forward guidance would have very small effects). Has this work been done? How much uncertainty about future interest rates was there prior to forward guidance? By how much is forward guidance hoped to reduce this uncertainty? Are the MPC hoping that all of the reductions in actual uncertainty are translated into reductions in perceived uncertainty too? How are the Bank intending to monitor whether these reductions are coming through as hoped for? If they don’t materialise, would there be some compensating loosening via another instrument (for this would surely be required as otherwise inflation and unemployment would be undesirably low). So far, we have not been told.
My own surmise is this. The effects of uncertainty about future rates, one-sided as they are when rates are pressed against their presumed floor, would be small even if all of the hoped for reduction were to come through (which seems unlikely, given the variable reception forward guidance has had so far, and the fascinating ambiguity that has been allowed to persist around what forward guidance was intended to do). The emphasis placed on the effects of uncertainty is probably just PR. If it wasn’t, there would be some compensating tightening, which there does not appear to be, and it would be hard to conceal it. It would not matter much that this was just PR, except for the fact that the whole point of forward guidance is to make monetary policy more transparent. Transparency is required so that everyone can scrutinise whether the MPC is doing what it said it would. Ideally, such transparency creates the expectation that the MPC will do what it said it would, because if it strays, it will be noticed. It looks to me like the emphasis on uncertainty is one of those things plucked out of the textbook to add to the list of reasons why forward guidance is a good thing in principle. If that was what was required to tip the balance so that this policy looked like a good thing to do, then perhaps it was a good thing. But without the information to understand how it figures, practically, in the estimation of the effects of the forecast period of constant rates, this kind of talk makes it harder to understand the MPC’s real thinking. And that will make it less likely that the MPC can manipulate expectations of future rates and get the hoped for stimulus. So, to add to the catalogue of transparency mishaps surrounding this policy (which featured prominently the question of whether forward guidance intended to loosen monetary policy or not) we can add the benefits of reducing uncertainty.