Whatever it takes
Why forward guidance in the EU carbon market is here, and is set to stay
“Within our mandate, the ECB is ready to do whatever it takes to preserve the euro. And believe me, it will be enough.”
Perhaps the most infamous remarks from a central banker came in the summer of 2012 when, in the midst of the Eurozone debt crisis, President of the European Central Bank (ECB) Mario Draghi delivered a speech at the Global Investment Conference in London.
Three words was all it took to fundamentally change the course of the debt crisis. Only 3 words, but it was enough to give investors confidence that Draghi had the resolve to bring down bond yields across the euro zone.
Forward guidance attempts to influence the decisions of investors, businesses and households by providing a series of guideposts for the expected future path of monetary policy.
For example, instead of simply cutting interest rates to stimulate economic activity, central bankers would communicate their policy intentions, suggesting that they expected rates to remain low in the future.
Central bankers resorted to forward guidance when they found their existing monetary tool box to be inadequate at influencing medium and long term interest rates. Stable long term expectations of low interest rates give people the confidence to bring forward major purchases or investments, such property.
Monetary policy forward guidance was first used in earnest by the then Federal Reserve Chairman, Alan Greenspan in the early 2000’s. Investors scrutinised every word and body language cue for hints as to what was really going on inside the mind of Greenspan. Any edge, however small could be extremely valuable to an investor if it told them what the central bankers next move was likely to be.
However, it was in the period after the Great Financial Crisis (GFC) of 2008/09 that forward guidance went on steroids and became a recurring feature of central bank activity. As economies and markets became more and more hooked on leverage, even very small changes in monetary policy could have outsized impacts on financial markets. Forward guidance after the GFC attempted to prevent surprises that might disrupt the markets and result in an eruption in asset price volatility.
Words matter, but actions matter too.
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