Boom! The ECB and Bank of England join the ‘forward guidance’ party

July 4, 2013

The Eurotower, home of the ECB and now of forward policy guidance, in Frankfurt (Hannelore Foerster/Bloomberg )

Americans may be preparing for a day of hot dogs, beer, and fireworks this July 4, but it was central bankers in Europe who were showing some real independence.

In policy meetings Thursday, European Central Bank and the Bank of England both took a decisive step toward telling markets what they expect to do in the future: Namely, "forward guidance" that they intend to keep near-zero interest rate policies in place for quite a while to come. It is an effort to change expectations, to push back against the idea that those central banks will get into interest-rate-hiking mode the minute their economies start to improve.

For years, ECB leaders have said they "never precommit" on the future path of interest rates, rather taking each month's situation as they encounter it. The Bank of England has worked under much the same construct. Now they're both changing, following a strategy that has been used by the U.S. Federal Reserve, the Bank of Canada, and recently the Bank of Japan to try to boost ailing economies.

Here's the crucial part of ECB president Mario Draghi's statement to journalists, buried in the middle of almost 1,200 words of the usual central banker gobbledygoop: "The Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time." He later indicated in his press conference that the decision was unanimous; unlike with some of the ECB's unconventional moves to ease policy, the German Bundesbank apparently was willing to go along.

Meanwhile, the Bank of England, holding its first monetary policy meeting under governor Mark Carney (he started Monday), was a little more subtle, but is quite clearly pushing the same direction. Carney was the original innovator in using this type of forward guidance to influence the economy, as governor of the Bank of Canada way back in 2009, and it showed in his first policy meeting in London. The Monetary Policy Committee's statement noted that longer-term British interest rates have recently risen, and that "the implied rise in the expected future path of Bank Rate was not warranted by the recent developments in the domestic economy." And the bank made clear that U.S. and ECB-style guidance on where its policies will go in the future is probably on the way. Noting that the Bank is studying forward guidance approaches, the statement added that "this analysis would have an important bearing on the Committee’s policy discussions in August."

European markets soared on the twin news of dovishness from the major Western central banks. The British stock market was up 3 percent, German stocks up 2 percent. The euro fell 0.7 percent against the dollar, helping reverse a runup that threatened to damage the competitiveness of European exporters. American markets were closed for the July 4 holiday.

So what to make of all this? A few important points.

First, the new communications, out of the Bank of England in particular, can be viewed a bit similarly to the comments of Federal Reserve officials last week, as they tried, in chorus form, to walk back expectations that the Fed will be tightening policy in the near future. They were trying to undo the damage from Chairman Ben Bernanke's comments at a press conference the week before, which prompted a sell-off on global bond markets and rise in rates across the globe. The Bank of England is in no small part saying: "Hey Mr. Bond Market. We don't know what you're doing exactly, but we certainly aren't planning to hike rates anytime soon."

That said, in both Britain and Europe, the central banks have, at this meeting, at least, found language to be a more palatable option than taking direct action. The Bank of England has been arguing about whether to expand its bond purchase program for months, with former governor Mervyn King being outvoted in his advocacy of the approach the last few meetings. We don't know yet how Carney voted in his first meeting, but we do know the outcome: There was again no change to the £375 billion in bonds the Bank will hold.

Similarly, Draghi and colleagues have floated the idea of cutting their short-term interest rate target even further, even as it could push a key bank deposit rate into negative territory. He suggested in his press conference that option is still on the table, but like his British colleagues did not actually pull the trigger

But in both cases (more QE in Britain and lower rates in the euro zone) the groundwork has now been laid. If those policies are enacted in the future, they will be part of a broader shift in how the central banks communicate about their policy.

Finally, if it wasn't already abundantly clear, it now is: These tools, including forward guidance and quantitative easing, are no longer strange curios that exist only in the theoretical world of academic economists. They are now being used in one form or another by all of the world's largest and most powerful central banks. What is really exotic about QE and forward guidance is that they are no longer exotic.

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Brad Plumer | July 4, 2013