The International Monetary Fund and the World Bank will today begin their marathon three-day annual meeting in Washington D.C. to review the last year and set out strategies for the future. And while it may not be as glamorous as the G8, G20 or Davos, this meeting is equally, if not more, important.
Among issues to be discussed the one that is sure to cause controversy is “forward guidance”, a public statement on the future course of economic policy, possibly used as a tool to reduce future financial volatility.
Central banks have begun to use these types of statements to inform markets and public about their monetary policy stance. The US Federal Reserve announced they would keep interest rates low until unemployment fell to 6.5%. The Bank of England promised no rate rises until unemployment fell to 7%. And famously, the European Central Bank said in July 2012 they would do “whatever it takes” to ensure the survival of the Euro.
Some economists are now calling for forward guidance from the IMF.
Proponents suggest a public announcement that the IMF would provide emergency finance to vulnerable markets would stabilise them, without the need for any actual financial intervention.
Explainer: the mechanics of forward guidance
When we accept the idea that expectations about the future are an important part of macroeconomic dynamics, then the incentive to make use of public announcement to influence these expectations arises.
Suppose that the central bank wants to achieve an inflation rate of 3%. If individuals and firms expect inflation to be 5%, then all contracts and wages will incorporate this expectation and lead to a rise in actual wages and prices by 5%, making it more difficult for the central bank to hit the inflation target.
If, however, the central bank were able to convince individuals and firms that inflation will be 3%, then the expected inflation embedded in contracts would be 3% and the increase in wages and prices would align with the inflation target.
One way to convince individuals and firms is to make announcements. Public announcements can also be useful in a situation where borrowers and lenders are uncertain about the future actions of the central bank because they have only imperfect information about the true state of the economy. Forward guidance in this case removes uncertainty and provides a clear signal of what the underlying economic situation is.
By influencing expectations and by reducing uncertainty, forward guidance can make monetary policy more effective and help stabilise the economy. The same logic could, in principle, be extended to other policymakers, like the fiscal authority or the IMF.
But there are complications. There are incentives for a central banks, after announcing it will keep interest rates at a particular level – and after firms and individuals embed this into their contracts – to renege on its commitment.
Suppose that the public believes central bank’s promise to keep interest rates at a certain level and acts accordingly. By cutting interest rates below the level promised, the central bank can then stimulate demand and put upward pressure on prices. Because contracts have already been signed, prices would not be able to adjust as quickly, and the increase in demand would have to be met by increased production. Employment would then go up.
The fact that the central bank might stimulate production and employment simply by reneging on its announcement reduces the credibility of the announcement, and without credibility any forward guidance becomes useless, if not damaging.
Other issues arise when interest rate levels are tied to non-monetary variables, like unemployment. Unemployment levels are determined by many factors, not just monetary policy. So, the risk is that while the central bank – as promised – takes a monetary policy stance that is conducive to lower unemployment, factors outside their control prevent unemployment from declining.
If this happens, does it make sense for the central bank to stick to it its announcement? And if it doesn’t, how will it cope with the inevitable loss of credibility?
Forward guidance for the IMF
So would an announcement by the IMF that they’d intervene to support valuable markets address financial instability? In theory yes, but in practice the answer is probably not.
For the announcement to have any impact, it must signal some new commitment from the IMF. The IMF has often intervened during the global financial crisis, but only under very tight conditions.
The IMF has gained a reputation for being tough on vulnerable countries; a toughness that does not seem to have had much success so far. So the IMF would have to announce a change in its policy approach; that is, it would have to announce that it is willing to provide “whatever assistance is necessary”, like the ECB did in July.
But would markets believe this change in policy? Having the reputation of a hard-nosed player, the IMF might not be credible when announcing something different from toughness.
And suppose the did IMF announces a policy change along the lines described above. There would still remain an issue of indeterminacy: what does excess volatility mean? Should the IMF announce a threshold for volatility?
How much financing would be needed to stabilise vulnerable markets might be unknown to the IMF itself. How could the IMF make a commitment on amounts that are unknown, especially given that its resources are limited and depend on contributions from member states?
However, supporters of forward guidance would say the ECB’s announcement, which is in many ways similar to the announcement the IMF could make, was successful. But there is simply not have enough data to establish whether or not that announcement restored stability and eventually what made it successful.
The IMF might take steps towards forward guidance, but it won’t have much of an impact on market expectations and stability in the short to medium term. In the longer term, forward guidance could become a more effective tool, but only if the IMF gives proof of having changed its policy views. In the meantime, forward guidance remains mainly a matter for central bankers.