Forward guidance could become trap for central banks-economist

[May 31, 2023]  By Leika Kihara

TOKYO (Reuters) - Central banks risk being late in arresting inflation if they rely too much on forward guidance - a tool used to communicate the future path of monetary policy, a widely respected economist told policymakers at a Bank of Japan-hosted event on Wednesday.

Forward guidance is an effective tool when central banks, faced with zero short-term interest rates, want to push down long-term borrowing costs by promising to keep rates low for a long period, said Athanasios Orphanides, a Massachusetts Institute of Technology professor and a former policymaker.

But by incentivising central banks to commit to keep rates low for long, forward guidance becomes a constraint when they need to swiftly tighten policy to rein in inflation, he said.

"Recent experience suggests forward guidance can become a trap," Orphanides said. "Unfortunately, it's not so helpful if upside surprises in inflation materialise."

The U.S. Federal Reserve and the European Central Bank, but not the Bank of Japan, ended up being behind the curve in addressing rising inflation with interest rate hikes, he said.

"Compared to forward guidance, clearer communication of a central bank's reaction function would avoid the trap and improve policy outcomes," he added.

The U.S. Federal Reserve building is pictured in Washington, March 18, 2008. REUTERS/Jason Reed

BOJ Governor Kazuo Ueda, who was present at the conference, said the very nature of forward guidance meant central banks took the risk of falling behind the curve whenever they were using the tool.

Central banks around the world followed in the footsteps of the BOJ in introducing unconventional monetary easing steps, including forward guidance, to combat the 2007-2008 global financial crisis.

Many of them now face the complex challenge of unwinding the stimulus, which combined low interest rates and a huge balance sheet, in response to the recent sharp rise in inflation.

The two-day conference titled "Old and New Challenges for Monetary Policy" ends on Thursday, and gathers central bank policymakers from many countries including the United States and Europe.

(Reporting by Leika Kihara; Editing by Jacqueline Wong)

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