Should central banks talk so much about raising interest rates?
Save time by listening to our audio articles as you multitaskCentral banks often telegraph what they might do before they do it. This kind of forward guidance is as old as central banking itself, according to Willem Buiter, a former rate-setter at the Bank of England. It is certainly as old as inflation targeting. The Reserve Bank of New Zealand quickly learned that it could move markets with its utterances . It now publicly forecasts its own decisions.
Why would they do that? The aim, as the paper put it, is to change public expectations about what central banks will do tomorrow, so as to improve the economy today. In a slump, a central bank might not have room to cut short-term interest rates by enough to revive the economy. It might then promise to keep rates low for longer than it otherwise would, even after hearing the siren call of an economic recovery. If its promise is believed, expectations of inflation will rise.
But when a central bank is not so constrained, the case for Odyssean forward guidance becomes less clear. If a central bank is free to act, why rely on words rather than deeds? In particular, why bother with forward guidance during a tightening cycle? There is, after all, no upper bound on interest rates. That question was recently posed on Twitter by Jason Furman, a former chairman of the White House’s Council of Economic Advisers.
One reason why central banks nonetheless like to offer guidance is precisely because they dislike the bang-bang approach. They prefer to change interest rates in small increments. Forward guidance allows them to move gradually, while signalling that the first small step will not be the only one. But if investors heed the guidance, the future steps will be priced in to longer-term interest rates straight away.
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