Gauging the effectiveness of central bank

forward guidance

M. Andersson, B. Hofmann

Directorate General Economics European Central Bank

• Publication of the central bank’s own Publication of the central bank’s own interest rate path: some pros and consinterest rate path: some pros and cons

• First experience by the Riksbank – a case First experience by the Riksbank – a case studystudy

• Comparative analysis between: Comparative analysis between: – Reserve Bank of New ZealandReserve Bank of New Zealand– Norges BankNorges Bank– RiksbankRiksbank

• Three avenues are examined:Three avenues are examined:– PredictabilityPredictability– Anchoring of long-term inflation expectationsAnchoring of long-term inflation expectations– Central banks’ (potential) leverage over the Central banks’ (potential) leverage over the

term structure of interest ratesterm structure of interest rates

Outline

Examples

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91b. Norway. 27 June 2007

Key Policy Rate

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71c. Sweden. 15 Feb 2007

Key Policy Rate

Norges bank June 2007

Riksbank February 2007

ProsPros

• Enhanced capability to steer market Enhanced capability to steer market expectations expectations → → leverage over leverage over short-/medium-term interest rates may short-/medium-term interest rates may be improvedbe improved

• Possibly more forward-looking Possibly more forward-looking internal discussions in the monetary internal discussions in the monetary policy committee policy committee

• Avoiding problems associated with Avoiding problems associated with MIR approach (e.g. extracting market MIR approach (e.g. extracting market expectations) expectations)

ConsCons• (Potentially) difficult for a monetary (Potentially) difficult for a monetary policy committee to agree on an entire policy committee to agree on an entire future path of policy rates future path of policy rates

• Potential criticismPotential criticism of pre-empting of pre-empting markets when market expectations align markets when market expectations align with the path … and …with the path … and …

• … … Potential criticism of credibility Potential criticism of credibility problems when they don’t problems when they don’t

• Media reports may become “too Media reports may become “too focused” on the published pathfocused” on the published path

Future Future pathpathCentral Bank Short-term interest rate

assumption

ECB market expectations

US Fed FOMC forecast: not specified Greenbook forecast: constant or time-varying

Bank of Japan Policy Board forecast market expectations staff forecast not specified

Bank of England

main scenario: market expectations

Bank of Canada

own interest rate path

Swedish Riksbank

main scenario: own interest rate path

Reserve Bank of New Zealand

own interest rate path

Reserve Bank of Australia

constant

Norges Bank main scenario: own interest rate path

Swiss National Bank

constant

National Bank of Poland

constant

Czech National Bank

own interest rate path

• Central banks Central banks use constant rates, use constant rates, market market expectations and expectations and own rates; own rates;

•Reserve Bank of Reserve Bank of New Zealand, New Zealand, Norges Bank and Norges Bank and Swedish Riksbank Swedish Riksbank regularly publish regularly publish their own interest their own interest rate path; rate path;

• Bank of Canada Bank of Canada and Czech and Czech National Bank do National Bank do not publish it. not publish it.

ECB ECB practicepractice

In June 2006 the ECB switched from constant In June 2006 the ECB switched from constant interest rate assumption (CIR) to market interest rate assumption (CIR) to market interest rate assumption (MIR)interest rate assumption (MIR)

ttnt ri

First experience by the First experience by the Riksbank – a case studyRiksbank – a case study

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Market interest 15 Feb 2007

Market interest 14 Feb 2007

Riksbank interest rate path published 15 Feb 2007

Riksbank repo rate forecast and market expectations in February 2007 (in % p.a.)

Riksbank repo rate forecast in February 2007 under the main and higher wage scenario (in % p.a.)

……In February 2007 In February 2007

Date Decision

14 February 2007 Raised 0.25 percentage points to 3.25 per cent29 March 2007 Unchanged at 3.25 per cent03 May 2007 Unchanged at 3.25 per cent19 June 2007 Raised 0.25 percentage points to 3.50 per cent

06 September 2007 Raised 0.25 percentage points to 3.75 per cent

The Riksbank defended the decision The Riksbank defended the decision ……

Expected and realised repo rates since 1999 (in % p.a.)

Figure1. Is the market always right?Repo rateexpectations according to implied forward ratesPer cent

Source: The Riksbank

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Note: Within the Riksbank this chart is better known as “the porcupine chart” (piggsvin chart)

“…() The interest rate path is quite simply the best assessment we can make at a given point in time, given the information that is then available. New information may change the picture of the economy and then the Executive Board will have to rethink how we set the repo rate.”

Irma Rosenberg, 6 June

June ReportJune Report

Riksbank repo rate forecast and market expectations in June 2007 (in % p.a.)

- On June 20, in the second 2007 issue of the Monetary Policy Report, the Riksbank published a new path of the expected repo rate.

- The June Report showed a higher repo rate path compared with that published in February

“…()One motive for raising the interest rate forecast is that the situation in the labour market is expected to be tighter than was forecast in February. More expansionary fiscal policy contributes to increased demand. The most important reason for revising up forecasts for inflation and interest rates is that cost pressures look to be higher”

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Market interest 20 Jun 2007Market interest 19

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Riksbank interest rate path published 20 Jun 2007

Comparative analysis of the Comparative analysis of the performances of the forward guidance performances of the forward guidance strategies adopted by the strategies adopted by the

• Reserve Bank of New Zealand Reserve Bank of New Zealand

• Norges BankNorges Bank

• the Riksbankthe Riksbank

Deriving monetary policy Deriving monetary policy surprisessurprises• Target surprises (TS) defined asTarget surprises (TS) defined as

TS = (A – E)/TS = (A – E)/σσ

The expected outcome can be derived from:The expected outcome can be derived from:

- Money market instruments (timely, “put - Money market instruments (timely, “put the money where mouth is”. the money where mouth is”. Premia can distort the measure) Premia can distort the measure)

- Surveys (not distorted by premia, less - Surveys (not distorted by premia, less timely) timely)

Survey-based vs financial market Survey-based vs financial market basedbased

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R2=0.71

Survey based (y-axis) and market based (x-axis) measures of monetary policy target surprises for New Zealand (in basis points, April 2001 — June 2007)

Deriving monetary policy path Deriving monetary policy path surprisessurprises• Path surprises (PS) defined asPath surprises (PS) defined as

ΔΔIFR = IFR = αα + + ββ**TS + PSTS + PS

Where Where ΔΔ IFR is the change in one-year-ahead IFR is the change in one-year-ahead implied forward rates, TS the target surprises. implied forward rates, TS the target surprises. The path surprises (PS) are derived as the The path surprises (PS) are derived as the errors from this regression.errors from this regression.

(i) (i) Does publication of an interest rate Does publication of an interest rate path enhance the short-term predictability path enhance the short-term predictability of monetary policy?of monetary policy?

New Zealand Sweden Norway 1 Norway 20

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Target Surprises

Path Surprises

Average absolute target and path surprises for the Reserve Bank of New Zealand, the Riksbank and Norges Bank (Sample period: for New Zealand and Sweden: January 1999 — January 2007, Norway 1: March 2001 - October 2005, Norway 2: November 2005 - June 2007)

(ii) (ii) Does the introduction of an interest Does the introduction of an interest rate path help to anchor long-term rate path help to anchor long-term inflation expectations?inflation expectations?

Dependent variables:

-5-year government bonds

-10-year government bonds

-Five-year ahead forward rates in five years time

Sample: January 1999 to January 2007 for New Zealand and Sweden. For Norway I: March 2001 - October 2005, for Norway 2: November 2005 - June 2007)

X is a matrix containing US, euro area and national macroeconomic announcements (used as controls).

(ii) (ii) Does the introduction of an interest Does the introduction of an interest rate path help to anchor long-term rate path help to anchor long-term inflation expectations?inflation expectations?5-year 10-year 5-year forwards

New Zealand Target Surprise 3.43 *** 2.22 *** 0.94Path Surprise 4.42 *** 3.56 *** 2.57 ***

Sweden Target Surprise 1.73 *** 1.08 * 0.53Path Surprise 2.16 *** 1.84 *** 1.41 **

Norway I Target Surprise 3.73 *** 2.00 *** 0.36Path Surprise 5.74 *** 2.47 *** -1.35

Norway II Target Surprise 4.19 *** 1.62 -0.36Path Surprise 2.24 * 1.54 * 1.89

Both target and path surprises, across economies (and across samples in the case Both target and path surprises, across economies (and across samples in the case of Norway), have lower coefficient values and fewer significance for the implied five-of Norway), have lower coefficient values and fewer significance for the implied five-year forward interest rates compared to the five and ten-year spot yields -> well year forward interest rates compared to the five and ten-year spot yields -> well anchored long-term inflation expectations.anchored long-term inflation expectations.

Results in line with previous studies applied on Sweden and the UK (Gürkaynak, Results in line with previous studies applied on Sweden and the UK (Gürkaynak, Levin, and Swanson (2006))Levin, and Swanson (2006))

(iii) (iii) Does an interest rate path Does an interest rate path publication improve central banks’ publication improve central banks’ leverage over the term structure of leverage over the term structure of interest rates?interest rates?This is not an easy task!This is not an easy task!

We try to tackle the issue by inserting a dummy on the on the occasions We try to tackle the issue by inserting a dummy on the on the occasions when the three central banks provide quantitative forward-looking when the three central banks provide quantitative forward-looking guidance. guidance.

If enhanced leverage (on the term structure of interest rates), the If enhanced leverage (on the term structure of interest rates), the coefficient on the dummy-interacted path surprise is expected to be coefficient on the dummy-interacted path surprise is expected to be positive and significant. positive and significant.

(iii) (iii) Does an interest rate path Does an interest rate path publication improve central banks’ publication improve central banks’ leverage over the term structure of leverage over the term structure of interest rates? Resultsinterest rates? ResultsFor New Zealand we find that the effect of the path surprise is For New Zealand we find that the effect of the path surprise is consistently larger when an interest rate path was published. consistently larger when an interest rate path was published. However, it is only significant for the five year segment. However, it is only significant for the five year segment.

The effect of the target surprise, on the other hand, is found to The effect of the target surprise, on the other hand, is found to be smaller. Can be interpreted as a shift in the bond markets’ be smaller. Can be interpreted as a shift in the bond markets’ focus from the very near term monetary policy stance.focus from the very near term monetary policy stance.

-> Weak evidence that a publication of a path can enhance -> Weak evidence that a publication of a path can enhance central bank leverage on the (medium) term structure of central bank leverage on the (medium) term structure of interest rates.interest rates.

ConclusionsConclusions

- Many pros and cons concerning publication of an interest - Many pros and cons concerning publication of an interest rate pathrate path

- The experiences from the Riksbank’s introduction were The experiences from the Riksbank’s introduction were mixed. The introduction in Norway was much smoother.mixed. The introduction in Norway was much smoother.

- A comparative analysis between the Riksbank, Norges bank A comparative analysis between the Riksbank, Norges bank and Reserve Bank of New Zealand reveals:and Reserve Bank of New Zealand reveals:

- Monetary policy decisions highly predictable in the three Monetary policy decisions highly predictable in the three economies, independent on whether an interest rate path economies, independent on whether an interest rate path was published or not.was published or not.

- Long-term inflation expectations well anchored.Long-term inflation expectations well anchored.

- Find (weak) evidence that a publication of a path can Find (weak) evidence that a publication of a path can enhance central bank leverage on the (medium) term enhance central bank leverage on the (medium) term structure of interest rates.structure of interest rates.