The Background Behind Kevin Warsh's "Disbelief in Forward Guidance" - Brookings Institution

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The Brookings Institution explained the background behind Federal Reserve (Fed) Chair nominee Kevin Warsh's statement—"I do not believe in forward guidance"—made during his Senate confirmation hearing, in an article posted on its website on the 28th (local time).

The article noted that while forward guidance was necessary and effective when short-term interest rates were at zero, there are also negative examples, such as during the COVID-19 pandemic, when it led to an unnecessary "delay in rate hikes."

Shin Hyun-Song, who was inaugurated as Governor of the Bank of Korea on the 21st, has also repeatedly expressed negative opinions about forward guidance.

The following summarizes the key points:

The primary tool the Federal Reserve uses to manage the economy is to raise or lower short-term interest rates. However, the Fed and other central banks have also adopted additional tools, one of which is "forward guidance." Forward guidance refers to central banks openly communicating about the expected path of short-term interest rates, mainly to guide financial markets. Former Fed Chair Ben Bernanke once joked that monetary policy is "98% talk and 2% action."

Delphic Forward Guidance and Odyssean Forward Guidance

Statements or outlooks on the future direction of monetary policy are referred to as "Delphic forward guidance," a term inspired by the oracle at the Temple of Apollo at Delphi and first defined by Chicago Fed President Charles Evans and his co-authors. For example, when the Fed publishes its Summary of Economic Projections (SEP), policymakers signal how they think rates might change. However, these are not explicit commitments. Widely adopted among central banks worldwide, Delphic guidance helps markets and the public better understand policymakers' outlooks and likely responses to economic changes.

Stronger and more explicit commitments about the future policy path are known as "Odyssean" forward guidance, named after the story in Homer's epic in which Odysseus ties himself to the mast. An example would be a promise to keep short-term rates unchanged for a "considerable period." This form of guidance can have a greater impact on markets and the economy than Delphic guidance, especially when short-term rates are at or near the zero lower bound and the Fed is seeking other ways to stimulate the economy. However, such commitments can limit the Fed's flexibility in responding to economic changes.

Why Forward Guidance Is Especially Important When Short-Term Rates Are at Zero

When short-term rates are effectively at zero—at the so-called "zero lower bound"—the Fed cannot lower them further to stimulate the economy. Some other central banks have set short-term rates slightly below zero, but the Fed has not. In such cases, the Fed has relied on other methods to boost the economy, focusing more on lowering long-term rates.

One such method is quantitative easing (QE), or large-scale purchases of long-term securities. Forward guidance is another tool. By assuring financial markets that short-term rates will remain low even as the economy shows signs of strengthening, the Fed aims to prevent a rise in long-term rates.

During the global financial crisis, the Fed lowered short-term rates to nearly zero in December 2008 and, during the sluggish recovery, used QE and various forms of Odyssean forward guidance to support the economy. For example, in August 2011, after significant debate and three dissenting votes, the FOMC stated that economic conditions were likely to "warrant exceptionally low levels for the federal funds rate at least through mid-2013."

As it became clear that the FOMC would keep rates at zero even after mid-2013, the Fed revised its forward guidance in December 2012, announcing that it would hold off on a rate hike as long as the unemployment rate was above 6.5%, inflation projections for the next one to two years did not exceed 2.5%, and long-term inflation expectations remained well-anchored. In March 2014, as the unemployment rate approached 6.5%, the Fed removed the specific unemployment rate reference from its guidance. The Fed raised rates from zero in December 2015, then waited another year before the next increase.

How Was Forward Guidance Used During the COVID-19 Pandemic?

Even after the worst of the pandemic had passed, the Fed was cautious about raising rates from zero. At its September 2020 meeting, the Fed declared that it would keep rates near zero "until labor market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2% and is on track to moderately exceed 2% for some time."

At the end of 2020, the Fed linked the timing for moving away from near-zero rates to the pace of asset purchases. Fed Chair Jerome Powell told markets that the Fed would provide ample warning "well before" it began tapering its asset purchases, and that rate hikes would only follow after tapering was complete. The Fed kept rates at zero through March 2022.

Former Fed Vice Chair Don Kohn and Brown University’s Gauti Eggertsson argued in a Hutchins Center working paper that this forward guidance "created unnecessary delays in raising rates by making the completion of asset purchases a precondition for rate hikes, and by promising to give much earlier notice about when and how asset purchases would end." As a result, the Fed was late in raising rates to counter an unexpected surge in inflation.

What Did Kevin Warsh Say About Forward Guidance?

Kevin Warsh, nominated by President Donald Trump to succeed Jerome Powell as Fed Chair, stated during his Senate confirmation hearing, "I do not believe in forward guidance." He added, "I do not think I should be showing you in advance what my future decisions might be."

Warsh argued that forward guidance limits the Fed's agility in responding to economic changes. He said that the Fed’s delayed response to the inflation surge during the pandemic was made "worse" by forward guidance. "The Fed tells the world what its outlook will be. But the Fed is made up of humans, and then they hold on to that outlook for longer than necessary," he said.

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