Central Banks and the Problem with Forward Guidance

Central Banks and the Problem with Forward Guidance
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By Philippe Herlin – Researcher in finance / Contributor to Goldbroker.com Forward Guidance is the new in phrase with central banks. It is supposed to reassure the market a few years in advance so that it can « anticipate » properly.

Central Banks and the Problem with Forward Guidance

The first one to have come up with this theory and implemented it is Ben Bernanke, who announced on September 13, 2012, that the Fed would not raise its interest rates before 2015. And, recently, Mario Draghi followed the same path while, until now, the ECB had refused to take any engagement spanning more than just a few months.

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So the markets can rest assured that the rates will remain low until there is a real economic recovery, and no one seriously believes that will happen. So the party continues, with banks getting free money from their central bank and the stock market having a ball.

But, after all, isn’t it only a cosmetic change? Not really. Let’s take a closer look. This means that the central banks take their decisions according to the stock market conditions. In other words, they are losing the initiative, or the power to create a surprise. This is actually a great change because, up to then, they were really proud of that power. Let’s just recall Alan Greenspan, quite the showman, who once said, ‘If you understand everything that I’ve just said, I haven’t said it correctly’… these days are gone.

But, more fundamentally, « forward guidance » translates into a fear, almost a manic panic for the central banks : the rising of long-term interest rates. Its effects would be devastating on the banks’ balance sheets and on insurance companies, as well as on the financing of public deficits. These rates have already, albeit moderately for now, risen in the United States and Europe, Germany included. If they kept rising, this could become dangerous rather quickly. Central banks can influence the short-term rates, the ones used to re-finance the banks. And, by keeping them close to zero and stating, as a matter of fact, that they will keep them low for the coming years, they are trying to weigh down on long-term rates. But, even though this influence may be real, it is still limited and would even be more limited in the face of inflation or more elevated risks.

This new central bank policy just goes to show that they’re kicking the can down the road and that they don’t know how to get out of their woes. Money printing and low rates are not creating growth, are not solving public debt problems, are only helping banks’ balance sheets on the margin and, above all, are creating still more dangerous bubbles than the 2008 subprimes one. In this context, « forward guidance » is just another expedient which, once again, doesn’t solve anything basically.


Philippe Herlin – Researcher in finance and junior lecturer at the Conservatoire National des Arts et Métiers in Paris / Contributor on Goldbroker.com

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