[Seungseop Song's Financial Light] Central Bank's 'Words Words Words'... Forward Guidance

"Ambiguity is a Virtue"... Why Central Banks Keep Silent
"Feels Good to Speak"... Central Banks Begin to Open Up
Changing Their Words Lowers the Status of Forward Guidance

Lee Chang-yong, Governor of the Bank of Korea, is holding a press conference after concluding the regular meeting of the Monetary Policy Committee at the newly constructed Bank of Korea headquarters in Jung-gu, Seoul, completed for the first time in six years on the 25th morning. Photo by Joint Press Corps

On the 25th, the Bank of Korea kept the base interest rate steady at 3.5%. This marks the third consecutive hold following February and April. Afterwards, Lee Chang-yong, Governor of the Bank of Korea, held a press conference with the media and emphasized, "Please do not think that Korea will never raise the base interest rate." While the market tends to believe that the rate hike cycle has ended, this was a kind of warning that the rate could be raised once more depending on future circumstances. Governor Lee's remarks that day attracted attention, and several media outlets summarized and published a Q&A session.

The words of a central bank governor always draw public interest. Not only in Korea but worldwide, all eyes are fixed on the statements of central bank governors. Of course, as heads of monetary policy, their remarks naturally attract attention, but it is also due to the unique characteristics of central banks. Central bank rate decision-makers have enormous influence on the economy, so they are extremely cautious with their words. In other words, there are very few opportunities to hear from central bank governors about the current economic situation, diagnosis, outlook, or solutions. That is why journalists focus intensely on Q&A sessions with central bank governors.

"Ambiguity is a virtue"... Why central banks have kept 'silent lips'

William McChesney Martin, Chairman of the Board of Governors of the Federal Reserve System (left), and George Wilder Mitchell, President.

“I was taught that I cannot predict interest rates from my current position. This is the difficulty faced by someone in this role.” December 1965, William McChesney Martin (then Chairman of the Federal Reserve)

“Statements and reports from the Federal Reserve Board (FRB) contain no explanations, judgments, or clarifications about current actions or inactions. There are no tips, predictions, threats, or promises about future actions. Given our knowledge, such things do not seem desirable.” - October 1966, George Wilder Mitchell (then Federal Reserve Governor)

The severity of central bankers' silence can be felt from the above remarks. There is a resolute determination not to say anything about what stance the central bank will take regarding the economic situation. They will not provide any hints about whether the central bank will raise or lower interest rates. During this era, U.S. central bank officials were said to have been extremely reluctant to engage in external activities such as debates or lectures for fear of misspeaking.

Bank of Korea Governor Lee Chang-yong is having a discussion on South Korea's monetary policy at the Peterson Institute for International Economics (PIIE) in Washington DC, USA, on October 15 last year (local time). On the right is Adam Posen, President of PIIE.
[Photo by Yonhap News]

“Speaking ambiguously is a virtue that central bankers must learn.”

Governor Lee has also mentioned the importance of speech. This was a statement he made during a lecture held on October 15 last year at the Peterson Institute for International Economics (PIIE) in Washington, USA. At that time, Governor Lee said, “You may notice that I speak less directly and somewhat ambiguously than before,” adding, “This is also a virtue that central bankers must learn.” This statement is closely related to 'Forward Guidance.'

'Speaking feels good'... Central bank heads start opening their mouths

Forward Guidance means 'pre-announcement' or 'future guidance.' It refers to central banks indirectly or directly informing the public about the future direction of interest rates. For example, stating that rates will be lowered to a certain level by a certain time, or that rates will be adjusted to a specific level if certain conditions are met, or announcing in advance that there are no plans to raise rates within the year. But this is strange. As mentioned earlier, silence was the basic stance of central bank governors, so how did Forward Guidance come about?

Alan Greenspan, Chairman of the Board of Governors of the Federal Reserve System [Image source=Yonhap News]

The first central bank governor to break the silence was Alan Greenspan, Chairman of the U.S. Federal Reserve. He served as chairman from 1987 to 2006, holding the longest tenure in U.S. history. Early in his tenure, Greenspan was reluctant to talk about interest rates, but by the 1990s, he began to gradually share his thoughts on rates. A paper written by the U.S. Federal Reserve in May 2021 states that “in the late 1990s, the Fed occasionally provided short-term Forward Guidance.” Later, as the global financial crisis began, Ben Bernanke, Fed Chairman, officially introduced Forward Guidance in 2011, and it started spreading to various countries.

Forward Guidance gained popularity in many countries because it could increase the speed and effectiveness of fiscal policy. One might think, “Isn't it enough just to lower interest rates? What effect could a few words have?” But that is not the case. Suppose the central bank announced at the beginning of the year that it would continue to lower the base interest rate throughout the year. Commercial banks could predict how much rates would fall by year-end thanks to the announcement and would try to lend more money quickly to customers. Various economic agents could borrow money faster, and the central bank could swiftly achieve its goals of economic stimulus and inflation increase.

Forward Guidance began to be adopted especially in countries where the base interest rate was already low. Particularly in advanced countries where the base rate was close to zero percent and inflation was low. The base rate was already so low that there was no clear method, and Forward Guidance suddenly appeared. The European Central Bank (ECB) is a representative example. In July 2013, the ECB issued Forward Guidance for the first time, stating that “the base interest rate is expected to remain at a low level for an extended period.” This announcement aimed to keep rates low for a long time to raise inflation.

Bank of Korea Governor Lee Chang-yong is explaining the base interest rate hike at a press conference held at the Bank of Korea in Jung-gu, Seoul, on May 26 last year. Photo by Joint Press Corps

Then, who was the first person to introduce Forward Guidance in Korea? As you might have guessed, it is Governor Lee Chang-yong. Governor Lee, who took office in May 2022, said at his first Monetary Policy Committee meeting, “It is necessary to operate monetary policy with a focus on inflation for the time being.” In the monetary policy direction meeting in November of the same year, the final interest rate level suggested by six Monetary Policy Committee members was disclosed. Governor Lee explained, “We decided to present Forward Guidance to communicate the Monetary Policy Committee's thoughts more transparently with the market.”

Words once spoken cannot be taken back... Forward Guidance's position 'shaken'

Of course, there is also considerable criticism of Forward Guidance. It is argued that it may increase uncertainty or cause unintended negative consequences. Suppose the central bank said it would lower the base interest rate only slightly, but due to misjudging the economy, it actually lowered it significantly. Economic agents who prepared based on the central bank's Forward Guidance would be caught off guard. Trust in the central bank's words would also decline. This means that Forward Guidance, which seems only beneficial, can be harmful in the long term.

Jerome Powell, Chairman of the U.S. Federal Reserve Board, is holding a press conference after concluding the Federal Open Market Committee regular meeting at the Federal Reserve headquarters in Washington DC on June 15 last year (local time).
[Image source=Yonhap News]

Jerome Powell, current Chairman of the U.S. Federal Reserve, has also faced difficulties because of Forward Guidance. Ahead of the June 2022 meeting, Powell said, “There will be no giant step (a 0.75 percentage point rate hike).” This was Forward Guidance indicating no sharp rate hikes. However, U.S. economic indicators rapidly deteriorated in a short period, and the Fed took a giant step. He undermined the central bank's credibility himself.

Governor Lee has also been under scrutiny for Forward Guidance. In October last year, Yoo Dong-soo, a member of the Democratic Party of Korea, stated during a national audit that Governor Lee's Forward Guidance caused turmoil in the foreign exchange market. Yoo said, “Governor Lee said he would gradually raise rates in the future, but as the person responsible for monetary policy, mentioning specific points was inappropriate,” and criticized, “As the situation changed, Governor Lee's stance and remarks also changed. Previous statements clearly have regrettable aspects.”

Christine Lagarde, President of the European Central Bank (ECB)
[Photo by Yonhap News]

There has been analysis that Forward Guidance has entered an era of decline due to COVID-19. Central banks that failed to predict economic conditions properly raised base interest rates rapidly. Christine Lagarde, President of the ECB, also said last year, “We are much more flexible in that we do not provide any kind of Forward Guidance.” Reuters evaluated this remark as “nailing the final coffin on Forward Guidance.”

Governor Lee evaluated the criticism surrounding his Forward Guidance by saying, “People seem to take the past baseline scenario conditionally rather than as a ‘commitment’ or ‘promise,’” adding, “It is true that there are many communication difficulties in realistically moving away from the long-standing practice of considering it a virtue to avoid mentioning future interest rate paths as much as possible.” He also said, “We may need to reconsider at what pace we should change this practice. Change is undoubtedly difficult.”

Editor's NoteFinance is difficult. It is filled with confusing terms and complex backstories. Sometimes, you need to learn dozens of concepts just to understand one word. Yet finance is important. To understand the philosophy of fund management and consistently follow the flow of money, a foundation of financial knowledge is essential. Accordingly, Asia Economy selects one financial issue every week and explains it in very simple terms. Even those who know nothing about finance can immediately understand these 'light' stories that illuminate the 'fire' of finance.