Should the central bank signal its intentions when defining its monetary policy? This is the question posed by Kevin Warsh, the new Fed chairman.

During the great financial crisis, the economy was turned upside down. The benchmarks changed and central banks had to implement unorthodox strategies, such as large-scale asset purchases: exceptional circumstances called for exceptional measures.

Subsequently, to navigate this unprecedented situation, Ben Bernanke issued numerous communication signals to guide economic actors. The Forward Guidance procedure gave the Fed the ability to signal the directions it would take in order to reassure economic actors while reducing the volatility of financial assets.

This operation strengthened the status and role of central banks in day-to-day management. Now, Warsh wants to reverse this trend so that investors are more influenced by real economic data than by the central bank’s interpretation of it.

He wants to change the Fed’s communication, exclude forward guidance, reduce the number of FOMC meetings, limit the size of the statements after these meetings, and no longer make the table of forecasts of the members of this FOMC the alpha and omega of what will be done in the future of the central bank.

Two critical remarks

1- Investors will continue to make predictions based on the yield curve. Depriving them of information from the central bank means accepting higher uncertainty and therefore a larger risk premium, since the direction of monetary policy would be perceived as a surprise.

The recent rise in long-term US interest rates is surely a result of this factor.

2- Forward guidance has two dimensions. One can be to set an interest rate target and trajectory, the other is to explain the reaction that the central bank could have in light of economic and inflation conditions.

The first dimension is clearly too restrictive, but the second is necessary. Debt markets are now enormous, and the central bank must send signals like a driver signaling an overtaking maneuver or a change of direction with a turn signal. Central banks must activate this signal while recognizing that if conditions change, they will not be bound by it.

In a more complex and fragmented world, central banks still have a major role to play; they must signal their intentions to avoid overly abrupt adjustments that would be counterproductive. Monetary policy must adapt to this new world, but it must not exacerbate the risks. This is precisely what it would do by eliminating forward.