You may or may not know much about forward guidance, but it has been of constant attention on the minds of policymakers. Further, policymakers themselves don’t seem to be able to define it, and because of it they can’t seem to solve the bond market puzzle. In orthodox economics, forward guidance is either “Delphic” or “Odyssean.” As usual, there is a great deal of needless complication associated with either, for everything must be turned into a regression model or else economists are lost in common sense.
Delphic forward guidance is of the kind practiced by central banks before the 2008 global break. Pioneered in New Zealand, the central bank plainly states what it is thinking about the state of the world and therefore what guides the expected path of monetary policy. The problem with the “Delphic” version is in the more extreme policy cases, as much of the world found out before the GFC was ever finished.
If the central bank, for example, believes that its policies will be effective and maybe sharply so, then Delphic forward guidance can potentially thwart the policy before it actually becomes effective. In other words, if bond market participants get wind of these positive central bank expectations, bonds may selloff in “reflation”, thus raising market rates before the “stimulus” of low rates has a chance of doing its work.
The prospective solution to this problem is “Odyssean” forward guidance. Here, the central bank may recognize the potential opposing problem of Delphic guidance and overcome it by promising to keep up with “stimulus” even if the effects of “stimulus” start to become apparent. This was very clearly practiced in 2013 by the Fed who unusually committed to QE3, which was then thought open ended, tying it to the unemployment rate so as to keep the bond market from anticipating too much its future success.
The problem, of course, with all forward guidance is that it is as much based on a single assumption that has actually been disproven over time, time and again, especially the past few years of the “rising dollar.” Economists can’t figure out why interest rates are lower today than when QE3 was unleashed, and in fact UST rates in particular declined more after the QE’s than with it. To try to rectify this philosophical ground with reality, as it relates to Odyssean versus Delphic forward guidance there has been raised (going back as far as 2012) an Event-Study Activity Puzzle to sort out interest rate effects.
While it sounds a lot like something published in the New York Times next to its crossword, the overly complicated framework is really nothing more than economists saying “we don’t get bonds, like at all.” The reason for it is surprisingly (to economists) simple, and requires literally none of the math to appreciate.
All views of forward guidance presume that the Federal Reserve or whatever central bank has knowledge of future events that are relevant to bond market participants. In the case of Delphic forward guidance, that would be materially non-public information which markets are theorized as desperate to get their hands on; such as unpublished economic forecasts of inflation, output, and monetary policy. Thus, markets under this view are trying to read the “tea leaves” of the actual and limited policy statements so as to generalize more specifically what they might mean about the future.
In a new study just published by the Federal Reserve Bank of Chicago, authors Campbell, Fisher, Justiniano, and Melosi take up the task of trying to attribute to Odyssean forward guidance the answer to their “puzzle”:
Our work resolves the event-study activity puzzle by demonstrating that the FOMC moves market expectations of future interest rates in part by transmitting its views of future macroeconomic fundamentals. When these are strong, private forecasters revise their projections accordingly, while market participants mark up their expectations of future interest rates.
This builds on work the same authors put together in October 2016, after they first described this “puzzle” in 2012.
Throughout 2009 and into mid 2010, financial market prices indicated that the FOMC would raise interest rates sooner than its pre crisis interest rate rule would have prescribed, and from mid 2010 through mid 2011 financial market participants essentially believed that the FOMC would deviate little from this rule. Our model indicates these expectations of tighter-than-usual policy cost the US economy a decline in the output gap’s trough from -4 percent to -6 percent. At its August 2011 meeting, the FOMC became more specific about its forward guidance, forecasting that the policy rate would remain at its effective lower bound “at least through mid-2013.” Thereafter, interest rate futures began to indicate that the FOMC’s policy accommodation would last substantially longer; and we estimate that this contributed to a much more rapid recovery in the output gap than would have occurred otherwise
They are attempting to explain low bond market rates after 2011 as due to a positive shift toward Odyssean forward guidance. Furthermore, they are making the claim that it was wildly successful and in terms of the output gap! In order to make this assertion, however, the bond market in 2009, 2010, and the first half of 2011 must have been driven by Delphic rather than Odyssean forward guidance; meaning that the change in the guidance regime starting in August 2011 was responsible for what find in the history of especially UST rates – rather than, of course, the massive liquidity contradiction that “unexpectedly” erupted at that very moment.
Again, this is all disabused by recognizing the simple assumption at the center of all kinds of forward guidance, Delphic, Odyssean, or whatever next might have to be made up to reconcile further to reality. It all assumes that central banks are correct, and that their forecasts are valid. If, however, the bond market comes to realize what central bankers themselves started to admit (persistently optimistic) long ago then low rates especially after 2011 were not due to some Rube Goldberg tortured pretzel of mathematical logic but rather simply traded based on increasing doubts over the efficacy of both monetary policy as well as policymakers’ dubious forecasting abilities.
What the whole of forward guidance and its so-called puzzle distills down to is nothing more than economists attempting to reconcile reality to a still powerful central bank that hasn’t got it all wrong. It really is that simple, and so is the key to all the supposed mystery – central banks do, in fact, have it all wrong, and the bond market (and so much more) took a few years but finally figured that out. The timing of this monetary education in reality was the summer of 2011. No math required; just corroborated common sense not beholden to rigid ideology.
Though this stuff can seem complicated, there are times like this when it really doesn’t take much to figure out how we got into this mess and can’t ever seem to be able to get out.