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In hindsight, maybe forward guidance wasn’t such a great idea

Justin Bieber isn't the only Canadian suffering embarrassment abroad this week. Mark Carney has grabbed attention at the World Economic Forum in Davos for admitting that the Bank of England's forward guidance system might need to be shelved. It was a project that Mr. Carney spearheaded in his first meeting after taking over the helm on Threadneedle Street; confessing its failure just six months later is not just embarrassing, it's dangerous.

Mr. Carney isn't alone in "forward guidance" blunders. The concept of forward guidance – or explicitly stating future interest rate intentions – is a relatively recent phenomenon in central banking. The idea is simple: by convincing markets that short-term rates will remain low (or high), central banks can sway longer-term rates.

Explicit forward guidance first appeared in New Zealand in 1997 when the Reserve Bank announced a rate path for its three-month bills. A few other banks have since tried it out, including Norway and Sweden in the mid-2000s, and most recently, the U.S. and the U.K.

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The role of central banks expanded dramatically during the financial crisis. Interest rates across developed countries have hovered near zero for five years now, forcing central banks to find creative ways to stimulate their countries' struggling economies. As central bankers found that their traditional tools to manipulate interest rates weren't working, the U.S. turned to quantitative easing, and forward guidance has also popped up again.

Mark Carney introduced forward guidance to the Bank of England last August, announcing that the BOE will not raise the bank rate "at least until the Labour Force Survey headline unemployment rate has fallen to a threshold of 7 per cent."

In subsequent months, Mr. Carney spoke at length about how the 7-per-cent unemployment rate is not a trigger for rate hikes; rather it's the point at which he would "begin to consider adjusting policy." This came to a head last week, when the latest labour report showed an unexpected drop in the jobless rate to 7.1 per cent, just shy of the BOE's threshold.

Speaking in Davos yesterday, Mr. Carney admitted that in light of the unexpectedly low unemployment rate, the MPC "will consider a range of options to update our guidance."

Across the pond, the U.S. Fed has experienced the same problem. Ben Bernanke put transparency at the top of his agenda as Fed chairman, culminating in the Federal Reserve's adoption of explicit forward guidance in 2011. Since then, unemployment numbers fell much faster than expected and the U.S. jobless rate now hovers at 6.7 per cent – just above the Fed's 6.5 per cent threshold. The Fed has responded by adjusting its tone, promising that rates will remain low "well past" the point the unemployment rate threshold is breached.

This experiment in managing expectations has turned out to be trickier than central bankers may have thought. Tying interest rates to a numerical goal and then backpedalling is confusing, unnecessary, and will likely foster the volatility it intended to prevent.

Even worse, it threatens the credibility of these central banks, and will likely render future communications less valuable as markets become skeptical. Forward guidance risks going down in economic history as a well-intentioned failure.

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The Federal Reserve meets next week, and media reports indicate that they will need to tweak their guidance again. Even though the Fed has clearly indicated that it will hold down the federal funds rate until 2015, the chance of a rate hike, as implied by overnight index swaps, has crept higher since the Fed began tapering, with the latest data pricing in a 26-per-cent chance of a hike over the next 12 months. Markets appear to believe the Fed's promise on rates for now – but if guidance remains latched to contradictory thresholds, market rates could rise rapidly in the coming months as the unemployment rate continues to dip.

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