Odysseus, Oracle, and Central banks
The interest rate is the main monetary policy tool, and many central banks announce the interest rate levels they intend to set in the future. Such statements per se have also become a monetary policy communication tool called forward guidance or a ‘statement of intent’.
The main purpose of these statements is to reduce the uncertainty experienced by companies and households by influencing their expectations and, consequently, their decisions. By announcing the future monetary policy rate path, central banks shape not only medium-term expectations, but long-term expectations as well, thus affecting them over various time horizons. In turn, economic agents – businesses, households, and banks – make their decisions on consumption, savings, investment, and borrowing based on their expectations. The aggregate of these decisions ultimately influences price dynamics in the economy.
Statements of intent can take different forms. Some central banks communicate their future interest rate decisions through qualitative statements (signals), which are bare descriptions without any specific quantitative data. Other central banks add quantitative benchmarks to their statements, such as macroeconomic indicators that influence the interest rate. Both types of statements can be accompanied by the publication of the projected interest rate path.
Origins of forward guidance
Until around the 1990s, central banks were not particularly ‘talkative’. For example, the US Fed did not even report its decisions until the 1980s. It was believed that regulators improved the efficacy of monetary policy in not disclosing their actions (1, 2). The approach to central banks’ communication started to change in the 1990s: they switched to inflation targeting, and managing inflation expectations was necessary for this policy to be successful. Central banks realised that, to this end, it was extremely important to make their decisions transparent (1, 2).
In 1997, the Reserve Bank of New Zealand was the first central bank to publish short-term interest rate forecasts (it was also the first central bank to switch to inflation targeting and announce its target range in 1989). The Reserve Bank of New Zealand started to release forecasts on the interbank lending rate, which was based on the rates of 90-day bank bills. Back then, these forecasts were not considered monetary policy tools, and no studies of their effects had been conducted yet. The work released in 2008 demonstrated that the forecasts of the Reserve Bank of New Zealand impacted the market prices of futures on bank bills (futures reflect the expectations regarding the future market interest rates).
By that time, several other central banks had already published benchmarks of their future interest rate policy, in particular those of Norway, Sweden, Japan, and the US Fed (which, for example, stated in 2003 that the interest rate would remain at 1% over a ‘considerable period’). Forward guidance was extensively used in early 2010s after the global financial crisis. In the advanced economies, this was a period of extremely low interest rates that reached the zero lower bound (ZLB) (link in Russian). In such cases, standard monetary stimulus, such as the reduction of the interest rate, become less effective. Central banks started using non-standard measures, such as quantitative easing. Forward guidance was also classified as a non-standard monetary policy tool.
Studies confirm that central banks’ statements impact financial asset prices, industrial production, inflation, and short-term inflation expectations. These effects are a result of the lower uncertainty.
According to Ben Bernanke, former chair of the US Fed, ‘monetary policy is 98 percent talk and only two percent action’, i.e. central banks can shape market expectations of future policy through public statements. He called this ability ‘one of the most powerful tools the Fed has’. This well-known quotation means that central bank communications have effects which are as strong as those of actual decisions and, along with such decisions, serve as the main monetary policy tool.
Oracle and Odysseus
Forward guidance can take three main forms.
1. Qualitative statements. For example, the interest rate will be low ‘for an extended period’ or ‘economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period’ (US Fed, 2009).
2. Qualitative statements with quantitative benchmarks. For example, ‘this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent’ (US Fed, 2012) or the OCR would remain at 0.25 percent ‘for at least 12 months’ (Reserve Bank of New Zealand, 2020).
3. Quantitative forecast of the interest rate. For example, ‘the constant rate projections in this Report assume that Bank Rate is 0.5% for the next three years’ (Bank of England, 2014).
Depending on the form, a central bank can either fulfil its stated intentions or deviate from them. To understand whether the central bank undertakes to fulfil its intentions or not, it is important to analyse the context and form of such intentions.
Statements may be clear and specific, which is evidence of firm intentions, or more general and vague, which suggests flexibility. For example, the use of words such as ‘probably’, ‘most likely, or ‘is forecast’ points to slight uncertainty. Confident statements containing words such as ‘will be constrained’, ‘will be reduced’, or central bank ‘commits to’ suggest that the intentions will be fulfilled. In general, all statements can be classified into two groups: forecasts (which may not prove true) and commitments (which the central bank will fulfil).
For example, the US Fed’s statement in 2021 ‘projecting either no increase in the target range or one 1/4 percentage point increase by the end of 2023’ was flexible. The forecast did not prove true, since a rapid rise in inflation made the US Fed increase its rate in 2022 H1. Contrastingly, the Bank of Canada’s statement in April 2009 was less flexible and contained the following commitment: on 21 April 2009, the Governing Council lowered the rate from 0.5% to 0.25% stating that, ‘conditional on the inflation outlook’, the central bank ‘commits to hold current policy rate until the end of the second quarter of 2010’. The rate remained unchanged until June 2010.
If a central bank undertakes to fulfil its stated intentions, such a statement is referred to as ‘Odyssean’ forward guidance: in Homer’s epic poem, Odysseus orders his sailors to tie him to the mast, thus limiting his actions. Forward guidance in which a central bank does not undertake to fulfil the intentions stated is called ‘Delphic’ forward guidance: the Delphic oracle made ambiguous predictions. These terms were first introduced by Jeffrey R. Campbell of the Federal Reserve Bank of Chicago with co-authors in 2012 and it have been borrowed by other researchers since.
Most theoretical studies assume that central banks use Odyssean forward guidance. The Odyssean form of communication may have more significant effects on markets and the economy than Delphic communication, since it boosts markets’ confidence in the path of future monetary policy.
However, in practice, central banks use this form very rarely, as it limits the flexibility they may need if external or internal economic conditions change. A central bank’s withdrawal from its own commitments may call the reliability of forward guidance into question and undermine confidence in the monetary regulator itself and its policy. Thus, the history of statements of intent has mostly been Delphic, i.e. central banks communicate the expected interest rate paths in the form of qualitative or quantitative statements (forecasts) describing the economic conditions corresponding to such paths. In this case, it is not assumed that the interest rate path expected in the future will be followed if the underlying conditions change. Published interest rate projections have a certain value provided that the public does not interpret the path as a commitment.
Do central banks’ expectations and forecasts come true? Many central banks make mistakes projecting interest rates, although most forecasts prove to be accurate ( 1, 2). For example, the Norges Bank, which began to make interest rate projections in 2005, substantially deviated from its forecasts several times due to the global financial crisis, among other reasons. Former Deputy Governor of the Sveriges Riksbank Lars Svensson was one of the first to advocate inflation targeting and publishing the future monetary policy path. He described the Riksbank’s ‘dramatic experience’ of publishing inaccurate forecasts in 2009–2010 that were considerably at variance with market expectations (at first, the market expected an earlier and, later on, a slower rise in rates than the Riksbank predicted). As a result, the central bank’s actions pushed inflation substantially below the target and somewhat undermined the market’s confidence in its projections. However, shaken confidence in forecasts as a result of their inaccuracy has not caused central banks any serious reputational issues so far.
The high level of uncertainty about future economic development prevents central banks from making exceptionally accurate forecasts. This uncertainty is associated with frequent changes in internal and external conditions and future economic shocks which are impossible to predict. Since projections cannot be completely accurate, to maintain confidence in their monetary policy, central banks can publish the factors (link in Russian) that cause significant deviations of forecasts about interest rates from their actual values.
The Bank of Russia, like many other central banks, signals whether it is prudent and possible to further change or keep the rate by releasing Delphic communication (link in Russian) about the projected key rate path following policy meetings. Judging by the experience of foreign central banks that have been publishing policy rate forecasts for a long time and the Russian Central Bank’s experience (link in Russian), the Delphic approach may reduce the market’s uncertainty and make the monetary policy pursued more effective.
