US: The Gains and Losses of Withdrawing Forward Guidance

■ While withdrawing forward guidance increases the flexibility of monetary policy, it also increases the volatility of market expectations.  

■ This may not be a problem in stable times, but once the market becomes concerned about inflation or fiscal conditions, controlling long-term interest rates will become more difficult. 
 
In the Prestia Insight on June 5, I introduced that since the expansion of the term premium will weaken the transmission effect of monetary policy, for the Federal Reserve (FRB), merely fulfilling the two responsibilities of "achieving full employment" and "maintaining price stability" may not be enough to fulfill its "third responsibility" - maintaining "moderate long-term interest rates"*1. In this case, the central bank can take the following measures: (1) through unconventional monetary policies such as purchasing government bonds or yield curve control (YCC); (2) through strengthening communication through forward guidance and other means; (3) through coordination with fiscal policy, thereby enhancing its influence on market interest rates. Among them 

 
(1) refers to the means by which the central bank directly suppresses the premium in the bond market by purchasing long-term government bonds or guiding long-term interest rates (such as yield curve control policies). Since this increases the supply of funds in the market and produces a monetary easing effect, it may become a factor hindering "price stability" in the current environment, where the main task is to curb inflation. (2) It is a means of influencing the formation of financial market expectations by showing the market the future policy interest rate path. It can be used in both periods of monetary easing and monetary tightening, but if the market lacks confidence in the relevant guidance, its effect will be difficult to realize, and it will also constrain monetary policy in the medium term. (3) It is a joint commitment by the government and the central bank to maintain fiscal discipline and debt management to reduce the risk premium included in the bond market. Since its core role is usually to strengthen fiscal discipline, such as adopting a contractionary fiscal policy, the measures the central bank can take alone are relatively limited. 
 
At the Federal Open Market Committee (FOMC) meeting held on the 16th and 17th, under the leadership of Warsh, the newly appointed chairman of the FRB in May, forward guidance was removed from the statement because it was "no longer suitable for the current situation". From the perspective of the term premium, this policy adjustment is exactly the opposite of the direction described in (2) above. The FOMC also announced the establishment of five working groups, including those on communication policy and balance sheet policy, to conduct a comprehensive review of the monetary policy framework. Regarding the new monetary policy framework, I plan to provide further analysis after more details are released; however, based on initial impressions, its main purpose seems to be to increase the flexibility of monetary policy. On the other hand, the FRB is expected to provide less information to the market regarding the path of policy interest rates, and market expectations regarding long-term inflation, fiscal conditions, and other factors will be more prone to change. I believe there is a trade-off between maintaining a stable term premium and ensuring monetary policy flexibility. In normal times, this is less likely to occur; however, once the market begins to worry about inflation or fiscal conditions, the term premium will be more likely to widen, and controlling long-term interest rates will be more difficult than before.