MPC have stressed that their version of Forward Guidance, unlike the original Woodfordian policy to which the term normally refers, is quite different. Unlike the Woodfordian policy, the Bank of England are not communicating that rates would be lower for longer than one would predict based on a normal, historical reading of what the MPC cares about and how it sets about achieving it. There’s no change to the MPC reaction function, we are meant to understand. All that FG does is clarify what they were doing anyway.
Really? How does that work?
Since when have MPC followed a scheme for responding to events as they unfold which amounts to not even considering responding to news, at all, unless unemployment moves through some threshold? For example, since inflation targeting started in 1992, we know that you can fit a Taylor Rule (augmented with, say, a lag in the central bank rate) to the policy rate, and it will capture the main features of what the Bank of England tried to do. That rule will have rates responding to real and nominal things. You won’t get a better fit through those observed interest rates by trying to add indicator variables turning off the response to inflation unless an inflation forecast breaches 2.5 [a reference to the inflation ‘knockout’]. So unless the communication around forward guidance is completely empty, it DOES constitute a change in the reaction function. [Thanks to Richard Barwell of RBS for articulating these points so clearly to me over coffee.]
And are we meant also to consider that the MPC foregoing the normal convention of reconsidering their policy stance afresh each period amounts to not changing anything relative to before? If so, what is the point of ditching the ‘face each ball as it comes’ language? Unless that commitment is empty, this also constitutes a change in the MPC’s reaction function. Either they have laid out a data-contingent plan and intend to stick to it, as they say, in which case this is different from what went before, when there were no such pre-agreed plans, or they haven’t, in which case the words are hollow.
So, in short, either forward guidane does constitute a change in the reaction function, contrary to some of what has been claimed by MPC themselves. Or it does not, in which case the commitment made is empty. Which is it? Can someone explain?
One way out for the MPC is by reference to the ‘unwarranted’ rise in interest rates at that the MPC described as priced in to the yield curve at the August MPC meeting. Perhaps all the terminological tomfoolery is about trying to get the yield curve to behave as it always used to, for the two decades prior to August? Perhaps that is why the MPC needed to borrow a policy label used for something else, conjor up ‘wayposts’ and ‘knockouts’, to tether the yield curve so that it sways in the economic wind just as it always used to. No, that doesn’t seem to ring true either, does it? Are we to believe that the yield curve always did pretty much what MPC wanted it to, until now, when a new policy framework was needed? This is not very believable. The summer giration was hardly that unusual. What happened is that a new Governor arrived, one prepared to talk about future interest rates and compare them to the yield curve when previous Governors were not. Unfortunately, that same new Governor had also boxed himself into needing a new policy framework, or begin his Governership with a defeat.