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 interest rate path: some pros and consPublication of the central bank’s own interest rate path: some pros and cons First experience by the Riksbank – a case studyFirst experience by the Riksbank – a case study Comparative analysis between:Comparative analysis between: –Reserve Bank of New Zealand –Norges Bank –Riksbank Three avenues are examined:Three avenues are examined: –Predictability –Anchoring of long-term inflation expectations –Central banks’ (potential) leverage over the term structure of interest rates Outline

Examples Norges bank June 2007Riksbank February 2007

Pros Enhanced capability to steer market expectations → leverage over short-/medium- term interest rates may be improved Enhanced capability to steer market expectations → leverage over short-/medium- term interest rates may be improved Possibly more forward-looking internal discussions in the monetary policy committee Possibly more forward-looking internal discussions in the monetary policy committee Avoiding problems associated with MIR approach (e.g. extracting market expectations) Avoiding problems associated with MIR approach (e.g. extracting market expectations)

Cons (Potentially) difficult for a monetary policy committee to agree on an entire future path of policy rates (Potentially) difficult for a monetary policy committee to agree on an entire future path of policy rates Potential criticism of pre-empting markets when market expectations align with the path … and … Potential criticism of pre-empting markets when market expectations align with the path … and … … Potential criticism of credibility problems when they don’t … Potential criticism of credibility problems when they don’t Media reports may become “too focused” on the published path Media reports may become “too focused” on the published path

Future path Central banks use constant rates, market expectations and own rates; Central banks use constant rates, market expectations and own rates; Reserve Bank of New Zealand, Norges Bank and Swedish Riksbank regularly publish their own interest rate path;Reserve Bank of New Zealand, Norges Bank and Swedish Riksbank regularly publish their own interest rate path; Bank of Canada and Czech National Bank do not publish it. Bank of Canada and Czech National Bank do not publish it.

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

First experience by the Riksbank – a case study

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

The Riksbank defended the decision … Expected and realised repo rates since 1999 (in % p.a.) 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 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”

Comparative analysis of the performances of the forward guidance strategies adopted by the Reserve Bank of New Zealand Reserve Bank of New Zealand Norges Bank Norges Bank the Riksbank the Riksbank

Deriving monetary policy surprises Target surprises (TS) defined as Target surprises (TS) defined as TS = (A – E)/σ The expected outcome can be derived from: - Money market instruments (timely, “put the money where mouth is”. Premia can distort the measure) - Surveys (not distorted by premia, less timely)

Survey-based vs financial market based 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 surprises Path surprises (PS) defined as Path surprises (PS) defined as ΔIFR = α + β*TS + PS Where ΔIFR is the change in one-year-ahead implied forward rates, TS the target surprises. The path surprises (PS) are derived as the errors from this regression. Where Δ IFR is the change in one-year-ahead implied forward rates, TS the target surprises. The path surprises (PS) are derived as the errors from this regression.

(i) Does publication of an interest rate path enhance the short-term predictability of monetary policy? 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 October 2005, Norway 2: November June 2007)

(ii) Does the introduction of an interest rate path help to anchor long-term 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 October 2005, for Norway 2: November June 2007) X is a matrix containing US, euro area and national macroeconomic announcements (used as controls).

(ii) Does the introduction of an interest rate path help to anchor long-term inflation expectations? 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- year forward interest rates compared to the five and ten-year spot yields -> well anchored long-term inflation expectations. Results in line with previous studies applied on Sweden and the UK (Gürkaynak, Levin, and Swanson (2006))

(iii) Does an interest rate path publication improve central banks’ leverage over the term structure of interest rates? This is not an easy task! We try to tackle the issue by inserting a dummy on the on the occasions when the three central banks provide quantitative forward-looking guidance. If enhanced leverage (on the term structure of interest rates), the coefficient on the dummy-interacted path surprise is expected to be positive and significant.

(iii) Does an interest rate path publication improve central banks’ leverage over the term structure of interest rates? Results For New Zealand we find that the effect of the path surprise is consistently larger when an interest rate path was published. However, it is only significant for the five year segment. 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’ focus from the very near term monetary policy stance. -> Weak evidence that a publication of a path can enhance central bank leverage on the (medium) term structure of interest rates.

Conclusions - Many pros and cons concerning publication of an interest rate path - The experiences from the Riksbank’s introduction were mixed. The introduction in Norway was much smoother. - A comparative analysis between the Riksbank, Norges bank and Reserve Bank of New Zealand reveals: - Monetary policy decisions highly predictable in the three economies, independent on whether an interest rate path was published or not. - Long-term inflation expectations well anchored. - Find (weak) evidence that a publication of a path can enhance central bank leverage on the (medium) term structure of interest rates.