FOMC Minutes, Forward Guidance And An End To Tapering

As high income economies improve and the financial sectors stabilize, central bankers understandably and rightly, want to move away from the unorthodox policies that were necessary to avoid an even larger collapse and more suffering. At the same time, they want to reassure investors, businesses and households that they do not intend on increasing interest rates any time soon. The process by which central banks do this has been dubbed forward guidance.

Initially, as the Bank of Canada Governor, Carney used a date approach. This approach was eschewed by the Bank of England and the Federal Reserve for more a more data specific approach. Both central banks picked an unemployment rate, 7.0% and 6.5% respectively. To varying degrees, both central banks noted, for anyone who wanted to listen, that these were thresholds for which policy would be re-examined, not triggers for a change in policy.

Dare one say, both of the thresholds are being approached before most observers, including those at the central banks, expected. The substance of forward guidance must evolve with economic conditions. Those who argued that Carney would ditch forward guidance, confuse the communication mechanism with its substance. The FOMC minutes for last month's meeting show that US officials are also wrestling with the evolution of its forward guidance.

There seems to be a finite number of possible tactics. Officials could, for example, simply lower the current thresholds. This, however, may undermine the credibility of forward guidance. Another alternative could be to adopt a more qualitative approach. This is what the BOE seems to be doing.

A third possible course for the Federal Reserve is to emphasize its third mandate: financial stability. The problem with this is that if financial stability was threatened, the Fed would more likely have to be accommodative than restrictive. A fourth option would be to adopt a different threshold. To wit: The FOMC does not anticipate the need to increase interest rates while the core PCE deflator is below, say 1.7% (it stood at 1.2% at the end of last year). The fifth option is to find a different channel to communicate one's intention. The Federal Reserve can make its point, for example, through its quarterly interest rate forecasts.

No doubt with many business people and economists and various interests and sensibilities represented, there are bound to be advocates of each course. Judging from the January FOMC meeting, it is not clear the Fed has decided yet. Put in a larger context, we suspect the Fed will opt for the more qualitative approach, placing more emphasis on signaling the function of its interest rate forecasts.

In some ways, though, this evolution of the forward guidance communication style is largely a question of adaptation not speciation. This is also an important takeaway from the FOMC minutes. Not only did Bernanke put the Fed on the tapering path, but he also raised the cost of deviating from that path.

Even before the minutes it seemed clear to us that the bar to stop tapering or speed it up (which seems somewhat less relevant now in the face of the dramatic slowing of the US economy to something probably around 1.5% annualized, based on the current information set and conservative projections), is set high. The minutes reinforce this sense.

The key though is not how the economy does. Rather it is what the economy does relative to the Fed's outlook. The minutes make clear that last month, officials recognized that the pace of the economy in H2 were due to temporary factors that would likely be reversed in the H1 2014. This means that there should be little doubt that the Fed continues to taper. Forward guidance is the communication style to manage expectations. On the other hand, tapering, that is policy.