How Central Bankers Misjudge Forward Guidance

People buy now if prices are set to rise, but only if the message gets through.

One of the best ways to spur an economy is to get people spending, and policy makers have a number of tools to do that. Yet growing evidence suggests a favored approach of late—forward guidance by central banks—doesn’t work. Such guidance, usually focusing on the outlook for interest rates, is meant to make clear to consumers that prices are likely to rise soon, so buying big items now would be smart.

While people may agree with the buy-now logic, they still may not react as economists and policy makers expect, according to Boston College’s Francesco D’Acunto, Karlsruhe Institute of Technology’s Daniel Hoang, and Chicago Booth’s Michael Weber. That’s because they don’t understand the signal, the researchers find.

“If you’re an economist too much stuck in your model world, this is very surprising to you,” Weber says. On the other hand, he acknowledges that not everyone can follow the logic chain that leads from a central banker predicting depressed interest rates, to lower borrowing costs, to higher inflation, to the urgency of buying now. “If you’re not too detached from reality, it’s not surprising,” Weber says.

The researchers analyzed two events in which governments or central banks signaled that prices were set to rise. One was a 2005 announcement by the German government that the country’s value-added tax (similar to the US sales tax) would increase from 16 percent to 19 percent in 2007. The second was a 2013 statement by then European Central Bank president Mario Draghi that interest rates would stay low or decline further for some time. To economists, this statement was a clear signal that price inflation would soon follow.

Analyzing monthly surveys conducted on behalf of the European Commission both ahead of and after the announcement of the VAT increase, the researchers find that Germans quickly recognized the price implications. After the 2005 announcement, a higher portion of survey respondents said they expected price inflation and that now was a good time to buy big-ticket items such as furniture or electronics.

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Germans’ response to Draghi’s forward guidance, on the other hand, was nonexistent, the researchers find. The same monthly European Commission surveys, when conducted in 2013 and 2014, showed that respondents did not adjust their inflation expectations after the announcement or their assessment of whether it was a good time to buy. And the researchers did not find a delayed reaction that might suggest the information was trickling down via financial institutions or markets.

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Both the German government and the ECB were forced into the moves, though for different reasons. Berlin realized it faced fines from the European Union unless it rapidly decreased its deficit, so it sought to raise revenue as well as cut government spending. Germany’s VAT remained at 19 percent until July 2020, when the government reduced it to 16 percent for a six-month period as part of a response to the pandemic.

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Draghi, meanwhile, was facing a problem shared by many central bankers since the 2008–09 financial crisis. Normally, central banks can stimulate consumer spending simply by cutting interest rates. But with rates hovering at or near zero for many years after the crisis, this became impossible, and unconventional tools such as forward guidance emerged as a possible solution.

Clearly, that hasn’t worked. Economists at the New York Fed talked in 2012 about a “forward guidance puzzle,” contrasting the theoretical promise of such guidance with the subdued empirical results. More recently, studies by D’Acunto, Hoang, Weber, and another researcher, Maritta Paloviita of the Bank of Finland, suggest that only people with a higher-than-average IQ can correctly translate central-bank utterances into astute personal financial decision-making.

Weber warns that the public’s nonresponse to forward guidance could cast a shadow over another policy idea currently on the table: price-level targeting, which also relies on nonexperts understanding the mechanisms by which central-bank targets affect consumer prices—and acting on that understanding.

The German VAT experience suggests that a US national sales tax could be a fast acting and effective alternative, during the current pandemic or any other time, Weber says. Preannounced tax increases could do the work that central bankers hoped forward guidance would do, he says. Whether politicians would be eager to employ such a tool is another question.

“You can pretty much only do it if you’ve just been elected,” Weber says. “You lose a lot of voter goodwill right away, and it will take some time for the economy to grow enough to earn that back.”

A more general lesson would be to translate opaque Fed speak into a language that large swathes of the population can grasp. Failing that, it may be time to stop placing much hope in forward guidance as a way to spur consumer spending.

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