Goldman Sachs - A Guide to Guidance

8/9/2019 Goldman Sachs - A Guide to Guidance

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The Goldman Sachs Group, Inc. Goldman Sachs Global Investment Research

A Guide to Guidance

From the editor:With the recent adoption of explicit forward guidance as a stimulative

policy tool by the major European central banks, virtually every major central bank is

now using the tool in some form. The potential benefits and dangers of such policies

have therefore become Top of Mind. We ask Professor Michael Woodford widely

regarded as one of the leading monetary economists whether the greater use of

guidance is a good thing. His answer: YES, but the form of the guidance matters. We

then lay out our take on why some central banks remain hesitant to fully embrace thepolicy (concerns about inflation as well as tying their hands in an uncertain world), if

softer guidance can still be effective (somewhat, according to the Scandi experience),

why disconnects (Sep 18 taper NOT!) still happen (things change, making it hard to

sometimes follow through), whats better: asset purchases or forward guidance

(increasingly the latter), and what the market seems to prefer (deeds over words).

Source: wordle.com

Inside

Interview with Michael Woodford

Professor, Columbia University

4

The taper head-fake and whats nextKris Dawsey, GS US Economics

6

Forward (mis)guidance?Huw Pill, GS European Economics

8

Can words really equal deeds?

Robin Brooks, GS Global Markets

10

Efficacy of QE versus FG

Jari Stehn, GS US Economics

12

Lessons from forward guidance pioneers

Lasse Holboell Nielsen, GS European Economics

13

The issues raised by recent

policy experience concern the

means to steer interest rate

expectations, rather than the

desirability of doing so. And the

adoption of more explicit

communication to steer rates

remains justifiably controversial.

Huw Pill

Its a mistake to view asset

purchases and forward guidance

as two alternative means to

providing further stimulus, so that

we can avoid having to say more

about future policy if instead we

are acting to make additional

asset purchases.

Michael Woodford

[In terms of implications for

rates]the jury is still out on how

well forward guidance works.

What is clear, though, is that

markets prefer deeds to

words.

Robin Brooks

Economics, Commodities and Strategy Research

Top of MindOctober 31, 2013 Issue 18

Editor: Allison Nathan | [email protected] | +1 (212) 357-7504 | Goldman, Sachs & Co.ECS Executive Committee: Jeffrey Currie | Jan Hatzius | Kathy Matsui | Timothy Moe | Peter Oppenheimer | Dominic Wilson

Investors should consider this report as only a single factor in making their investment decision. For Reg AC certification,see the end of the text. Other important disclosures follow the Reg AC certification, or go towww.gs.com/research/hedge.html.


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Goldman Sachs Global Investment Research 2

Top of Mind Issue 18

US Japan

Latest GS proprietary datapoints/major changes in views

The cumulative weakness in the labor market over the last

three months has led us to push back our expectations on the

announcement of tapering to the March 2014 FOMC meeting.

We still expect growth to pick up from 1.6% in 2013E to 2.9%

in 2014E; the ISM indices are in strongly expansionary territory.

Datapoints/trends were focused on

The potential for more disruption around fiscal deadlines: (1)

December 13: targeted conclusion of House-Senate budget

negotiation, (2), January 15: expiration of spending authority, (3)

Mid-March: likely debt limit deadline.


We revised our $/JPY forecasts slightly lower on October 10

given a lack of near-term catalysts for a weaker Yen.


The national CPI that excludes fresh foods and energy pulling

out of negative territory in September for the first time since

December 2008.

A rise in household current conditions sentiment in September

for the first time in six months on favorable auto sales and a pre-

tax-hike rush in demand.

US manufacturing on the riseUS ISM manufacturing index

Japanese non-energy prices (finally) on the riseCore-core CPI (excludes fresh foods and energy), yoy %chg

Source: ISM, Goldman Sachs Global Investment Research. Source: MIC.

Euro Area (EA) Emerging Markets (EM)


We now expect the ECB to offer a longer-maturity LTRO, which

we believe would be constructive for the banking sector and

the economy during 1H14 rather than by the end of the year.


The euro has appreciated around 1% since the ECBs October

meeting, which adds to the downside risks to growth and

increases the chance of a rate cut, but we do not expect action

beyond a potential mention of concern at the Nov meeting.

Spain exiting recession, leaving GDP 7.4% below its 2008 peak.


China growth tracking around 9% as measured by our Current

Activity Indicator (CAI).


Rising concerns about another liquidity squeeze in China.

Continued declines in Brazilian industrial sector confidence to

the lowest level since July 2009 despite recent depreciation in

the BRL; Mexico has also converged to the sluggish growth

path of Brazil, but is better positioned to provide stimulus

(further rates cuts) given its much more benign inflation.

Spain (finally) growing againSpain GDP, %

Inflation deviation (Mexico vs. Brazil)% of CPI above inflation-targeting-midpoint, 3mma

Source: INE. Source: Haver Analytics, Goldman Sachs Global Investment Research.

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BRA MEX

Macro news and viewsWe provide a brief snapshot on the most important economies for the global markets


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As we approach the five-year anniversary of the US Federal

Reserve Board lowering US policy rates to their effective zero-

bound in the midst of the Global Financial Crisis, central banks

across the developed market economies faced with generally

improving but still-anemic growth continue to look to

unconventional policy tools to further stimulate their economies.

The use of explicit forward guidance is one of these tools, which

has been used by the Bank of Japan and other central banks for

some time and has been a crucial part of the Feds post-crisis

policy strategy, evolving from vague qualitative guidance in

December 2008 to more explicit calendar guidance in August

2011 (which committed to low rates until at least a certain date),

and to threshold guidance in December 2012, (which committed

to low rates until specific economic conditions were met).

In recent months, both the European Central Bank (ECB) and the

Bank of England (BOE) also began experimenting with explicit

forward guidance as a stimulative policy tool, marking a not entirely

new but important shift in approach given these central bankssubstantial reluctance to adopt such policies in the past. With

various forms of forward guidance now being implemented by

virtually every major central bank, the potential benefits and

dangers of such policies have become Top of Mind.

We interview Michael Woodford, a professor at Columbia

University whose seminal paper presented at the Jackson Hole

central bank conference in August 2012 was thought to

substantially influence the Feds September 2012 adoption of QE3.

We ask if the greater use of forward guidance is a good thing (yes,

it can reduce misinterpretations of policy and enhance its

stimulative effect), if threshold guidance is better than

calendar guidance (yes, because it is ultimately more credible), if

the softer version of forward guidance adopted by the Europeancentral banks will negate its effectiveness (yes, to some degree),

how he thinks about asset purchases versus forward guidance (its

a mistake to think of asset purchases as a way to avoid having to

talk about future policy intentions), and why the market and the

Fed have seemed so disconnected at various points this year

despite substantial attempts by the Fed to communicate more

clearly (there were mistakes in communication, but that does not

mean the situation would have been better if the Fed had instead

kept its mouth shut, especially in such unprecedented times.)

We then provide our take on these questions. Our chief European

economist, Huw Pill, looks at why some central banks remain

reluctant to embrace forward guidance especially on the

European side of the pond and thus have adopted softer forms of

it. But Lasse Holboell Nielsen, also of our European economics

team, uses the Scandi experience with explicit but conservative

forward guidance to suggest that softer forms can still be effective

in shaping policy expectations, with lessons for the ECB.

Jari Stehn of our US economics team then looks at the evolution of

the use of asset purchases versus forward guidance, with external

and our own analysis increasingly favoring forward guidance as a

policy tool. And Kris Dawsey, also of our US economics team, drillsdown into the disconnect between the market and the Fed around

the September 18 FOMC meeting when the market was clearly

surprised by the Feds decision not to taper concluding that

things had changed sufficiently heading into the meeting to give

the Fed pause in following through with the expectations it had

largely created for itself.

Finally, Robin Brooks of our global markets team looks at market

implications of these policies, with past experience in the US and

Canada suggesting that deeds still speak louder than words.

Allison Nathan, Editor

Email: [email protected]

Tel: 212-357-7504Goldman, Sachs & Co.

The evolution of central bank communication/transparency

Source: Goldman Sachs Global Investment Research.

A Guide to Guidance

Central

bank policy

intentions

shrouded

in secrecy

1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013

BOE, Feb-93

Publishes first

Inflation

Report

Fed, Mar-93

Begins

releasing

minutes of

FOMC

meetings

(with 68

week lag)

Fed, Nov-93

Begins

releasing

transcripts

of FOMC

meetings

(with 5 year

lag)

Fed, Feb-94

Begins

explicitly

announcing

changes in

federal funds

rate target

RBZ, Jun-97

Begins

announcing its

forecast of

future short-

term interest

rates

BOE May-97

BOE granted full

independence

and MPC

established

BOE, Oct-98

BOE MPC

expedites release

of Minutes from

5 weeks to 2

weeks (13 days)

BOJ, Jan-98

Monetary

policy

meeting

begins on a

monthly

scheduled

basis (ad-

hoc before)

ECB, Jan-99

Begins conducting

monetary policy,

which includes

some aspect of

forward guidance

in its "intention to

maintain a 3%

MRO rate for the

foreseeable future"

Fed, Jan-00

Commits to

publishing a

statement

after every

FOMC

meeting;

Replaces

tilt with

statement

describing

balance of

risks to

economic

outlook

intended to

cover an

interval

extending

beyond the

next FOMC

meeting

BOJ, Oct-00

Begins

publishing

report on

growth and

inflation

outlook

BOJ Mar-01

Initiates

outcome-based

guidance for its

rate policy

Fed, Mar-02

Begins

releasing

votes of

individual

Committeemembers

and

preferred

policy choice

of any

dissenters

Fed, Aug-03

Begins toissue direct

qualitative

statements

about its

future policy

inclinations

in various

verbal

formulations

BOJ, Oct-03

Makes the

conditions for an

exit from QE more

transparent,providing three

conditions that

must be satisfied

before ending QE

Fed, Feb-05

Expedites

the release

of FOMC

minutes to

make them

available

before the

subsequent

FOMC

meeting

NorgesBank,

Nov-05

Begins to regularly

release forecasts

of the future path

of their policy rate,

2-3 years ahead

BOJ, Mar-06

Introduces the

"understanding ofmedium-to-long-term

price stability" in

numerical form (0-2%);

Introduces the "two

perspectives

approach" that

considers the dual

mandate as well as an

assessment of risk

Riksbank,

Feb-07

Begins to

regularly

release

forecasts of

the future

path of their

policy rate

Central

Bank of

Iceland,

Mar-07

Begins toregularly

release

forecasts of

the future

path of their

policy rate

Fed, Nov-07

Increases the

frequency and

expands the

content and

horizon of its

publicly-

released

inflation and

economic

activity

forecasts

BOJ, Jul-08

Announces: (1)

The release of

statement

explaining their

latest

assessment of

the economic

and price

situation after

every meeting

(not just those

when interest

rates are

changed) (2)The October

semi-annual

economic and

price outlook

will release

forecasts for a

longer time

horizon

(3) Risk

balance charts

will be

published more

frequently (4)

Release of

minutes will

always be

before the

subsequent

meeting (5)

Monthly

economic

assessments

in Japanese

will bereleased the

day after the

Board meets

(English

version two

days after)

BOC, Apr-09

Initiates calendar-

based guidance,

conditional on the

inflation outlook

Fed, Apr-11

Chairman

holds first

press

conference

following a

FOMC

decision

Fed, Aug-11

Shifts to

calendar-

based

guidance

from vague

qualitativeguidance

BOJ, Feb-12

Sets inflation

"goal"

Fed, Dec-12

Replaces

calendar-based

guidance with

outcome-based

guidance

("thresholds)

BOE, Mar-13

Remit adjusted

to further

formalize

inflation/growth

flexibility; BOE

invited to

consider forward

guidance

ECB, Jul-13

Introduces

forward

guidance -

not new in

its history

but a

significant

step away

from the

mantra "we

never pre-

commit" that

Trichet

established

BOE, Aug-13Introduces

outcome-based

forward guidance

(first time it has

used forward

guidance of any

kind)

Red = Fed Purple = ECB Blue = BOJ Green = BOE Orange = Notable innovators/ others

BOJ, Apr-98

Introduction

of Bank ofJapan law

that clearly

sets out the

dual

mandate of

sustainable

growth

under price

stability

BOE, Jun-98

Bank of EnglandAct formalizes

independence

Fed, May-99

Releases a

statement

about the

FOMC

decision

even after

no change in

federal funds

rate target;

Begins

announcing

policy tilt

indicatingmost likely

future

interest rate

action

between

then and the

next FOMC

meeting


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Michael Woodford is the John Bates Clark Professor of Political Economy at Columbia University.

His paper Methods of Policy Accommodation at the Interest Rate Zero-Bound presented at

Jackson Hole in August 2012 was widely regarded as the seminal paper at the central bank

conference. Below he discusses the benefits of forward guidance, even if it is no panacea.The views stated herein are those of the interviewee and do not necessarily reflect those of Goldman Sachs.

Allison Nathan: Havent central banks

always tried to influence interest rate

expectations? What is so special

about forward guidance today?

Michael Woodford: No, central banks

have not tried to do things that were at

all similar to this in the past. Until quite

recently, all central banks were very

reluctant to say things in advance

about future policy decisions, and this

reluctance remains to varying degrees at

many banks. The forward guidance

adopted by the Fed and other central

banks, which tries to influence

expectations by actually saying things about policy intentions, is

therefore a new policy tool and indeed one that has become more

important given the near-exhaustion of the most traditional policy

tool adjusting policy rates as rates across the major economies

already hover around their effective lower bound.

Allison Nathan: What are the benefits of forward guidance?

Michael Woodford: If policy expectations matter and I think it is

pretty clear that they are crucial to how longer-term assets end up

getting priced then there are two kinds of advantages of explicitly

discussing future policy by the central bank. One advantage is that

it can reduce misunderstandings about policy intentions,

which, in turn, can reduce uncertainty for the central bank about

the effect of its policy on the markets. In principle, talking directly

about policy intentions would allow the use of more complex

policies, which might not otherwise be pursued for fear that they

would not be understood without explanation. The second general

type of gain from explicitly talking about future policy is to help

ensure that the policy committee itself will follow through

with its commitmentseven though it may have motives to depart

from them later on.

Both of these potential advantages are particularly clear when youreach an effective lower bound on policy rates. At that point,

convincing people that the policy rate will remain lower for

longer can help ease financial conditions today, providing

additional stimulus to the economy when traditional tools no longer

can. But talking about the intention of lower for longer is crucial

because being at this lower bound is a very unusual situation,

so there is little past experience that people can look to in

order to anticipate how the central bank is going to respond.

There is also a clear need for the central bank to commit itself in

advance in order to achieve the stimulative benefit. That is because

of course later when the stimulus has worked and the economy

is improving - the bank will have little motivation to actually keep

rates low (the so-called time inconsistency problem) unless they

committed to do so in advance. To overcome that problem, the

central bank needs to make an explicit promise that would be

difficult or embarrassing to just completely ignore later.

Allison Nathan: What are the dangers of forward guidance?

Michael Woodford: The most obvious danger, which has likely

been the main reason for central banks reluctance to talk about

future policy in the past, is the possibility that a policy

commitment that looks sensible at some earlier time turns out

to be unwise because things happen in the meantimethat the

central bank did not expect. Those costs can be reduced without

losing all of the potential benefits of forward guidance if the central

banks think carefully about what kind of commitments about future

policy should be made. It makes sense to avoid unnecessary

specificity about things that do not need to be specified too

precisely in order to achieve the desired change in expectations.For example, in the case of a commitment to keep the federal

funds rate low for longer in order to stimulate the economy today,

the central bank could make a very specific commitment about the

path of the policy rate over time. But there would be much more

likelihood of embarrassment in that case than if the bank instead

committed to keep rates low until certain economic conditions

arise, whenever that may be.

Allison Nathan: The BOE and the ECB have said that the

intention of their shift to forward guidance has been to clarify

their policies rather than to commit to lower for longer. Will

this approach negate the benefits of the guidance?

Michael Woodford: Yes, to some degree. In the case of the Bankof England, the structure of their statement with several so-called

knock-out provisions - as well as their insistence that the

statement was nothing more than a clarification of the BOEs

normal reaction function, has given people little reason to change

their prior beliefs about how soon the Bank would raise rates.

Because of this, the statement does not seem to have moved

market expectations much and in the way that the BOE thought it

should. Similarly, the ECB has taken small steps towards doing

something that you might think of as forward guidance, but has

also done so quite hesitantly; they are also inclined to deny that

they are committing themselves at all about future policy. Given

the aversion to talking about policy intentions in the past, this

hesitation is not surprising, nor is the fact that even central banksthat have decided that they should experiment with the policy do it

in a way that simultaneously denies that they would ever do it,

because it goes against their instincts. But that to some extent

defeats the purpose of the policy. Their approach is quite

different from that of the Fed, which has more clearly embraced

the policy of lower for longer.

Allison Nathan: Is the Feds shift to outcome-based or

threshold guidance from calendar guidance a good thing?

Michael Woodford: Yes, because threshold guidance is

ultimately more credible.The problem with calendar-based

guidance is that if there is a real promise to keep rates at a certain

level until a certain point in time no matter what happens, it wouldbe a pretty reckless policy. And because the policy would be

reckless, it would ultimately be hard to believe. That would be the

case unless the central bank restricted itself to a short horizon over

which there could not be many surprises. But if the horizon is too

short, the impact on future expectations would be small. So I think

Interview with Michael Woodford


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the possibility of making a commitment that extends far enough

into the future for it to be news about future policy that would

significantly matter to asset pricing is much more plausible if it is

based on economic conditions rather than just based on a date.

Allison Nathan: There have been several instances when the

use of forward guidance has had an opposite impact than the

central banks intended why?

Michael Woodford: The use of forward guidance is not some kind

of magical tool where the mere fact that the central bank says

something means that people will then think exactly that. A central

bank needs to give people a reason to think something new or

different about what it is going to do. A critical part of effective

policy is therefore understanding what people will think they

are learning about the banks policy.An example of this that I

talked about in my Jackson Hole paper last year was the

experience of the Swedish Riksbank in April 2009, when they cut

their policy rate to 50 basis points and accompanied this with a

statement and a published projected rate path that showed policyrates remaining at 50 basis points - the lowest level ever - until the

beginning of 2011. To the Banks surprise, market forward rate

expectations rose rather than fell following the announcement.

Why? Because the big news of the statement was not the

central banks lower projected rate path, which was in any case

just a projection and not a commitment, but that the central bank

was apparently regarding 50 basis points as a floor, which was

higher than at least some market participants had previously

guessed. That news shifted the markets most likely expected path

of the future policy rate up rather than down.

Allison Nathan: How would you explain the violence of the

bond market selloff in May/June, which came in response to a

very small change in the Fed's message?

Michael Woodford: I am inclined to think that it indicated some

mistakes in Fed communicationprior to May that led to two

possible types of misinterpretation about the Feds intentions.

First, some people may have interpreted the start of taper talk as

a signal that the Fed was trying to withdraw accommodation more

broadly, and was also preparing to start raising interest rates. That

was a surprise to the FOMC; they didn't think they were saying

anything that would suggest they were preparing to raise rates.

But they had left themselves open to that misinterpretation by

failing to explain earlier the criteria that would determine the path

of asset purchases in a way that sounded very different from the

criteria that would determine the path of interest rates. The

forward guidance about both asset purchases and interest rates

focused on labor market conditions and sounded very closely

related. I do not think that the Fed meant for the criteria to be the

same, but they failed to sufficiently explain why they would not be.

Second, there may have been a number of people who thought the

purchases were going to continue at the current rate for a lot

longer, and learned suddenly that they would not. If that was news

to people, it was again a failure of communication because I doubt

that the Fed had ever thought asset purchases would continue at

the current rate beyond 2013. Despite these failures, it would be

a mistake to conclude that the Fed should not have started

speaking about tapering when it did; the problems would not

have been avoided if the Fed had just kept its mouth shut, because

the misinterpretations would still be there. And shutting yourmouth is potentially setting you up for an even harder adjustment

later when the misinterpretations must eventually be exposed.

Allison Nathan: Why was the market so surprised by the

decision not to taper at the September FOMC?

Michael Woodford: It certainly seemed to me that during the

summer the ground was being prepared for a slowing of the rate of

purchases. As to why they did not actually do it, I think it was a

reaction to the fact that the market had responded to those earlier

hints more violently than expected. And there was evidently a

decision that they could not risk a further unexpected negativereaction to an actual announcement of tapering. That was probably

a mistake in judgment. By September, a modest reduction in

purchases was widely expected, so I do not think there would have

been a big negative reaction to that announcement. But, by

blinking when they did, I fear that they have made a negative

reaction more likely in the future, because they are now back to

square one, with people once again lacking a clear sense of how

close the Fed is to tapering and thus vulnerable to surprise.

Allison Nathan: Is there actually greater volatility and

uncertainty in the markets as a function of this desire to

communicate more, but not quite getting it right?

Michael Woodford: I don't think so, because the question is: whatwould be people's understanding of policy if the Fed had not tried

to talk about it at all? There would be a lot of uncertainty if the Fed

were adopting a policy of silence, especially given that we are in

unprecedented territory. When conditions are unusual is exactly

the time when trying to provide some explicit guidance is

potentially most valuable, even if it is not a panacea.

Allison Nathan: How important are asset purchases as a signal

of commitment to accommodative policy?

Michael Woodford: I think that a lot of the effects of asset

purchases have been signaling effects.The advantage of

purchases as a signal is that it is something that people see being

done. It's not just talk, so it grabs peoples attention. And the fact

that action is being taken gives some indication of where the

majority of the FOMC stands. But the likelihood that purchases

have had some signaling effect does not necessarily mean that

they are the most effective way of providing the signals that the

central bank wants to send. There has at times been a temptation

to view asset purchases and forward guidance as two alternative

means to providing further stimulus, so that we can avoid having to

say more about future policy if instead we are acting to make

additional asset purchases, and I think that is a mistake. To the

extent that the main goal of purchases is to give a signal, then you

should think consciously about what signal you are trying to give

and be comfortable delivering that signal. Thinking about asset

purchases as part of a coherent and consistent attempt to give

signals about future policy is one thing. But it's very different from

the idea that there will be a mechanical effect of purchases that

allows you to avoid saying anything about future policy intentions.

Allison Nathan: Whats next for Fed communication?

Michael Woodford: It would be valuable for the Fed to provide

more guidance about the process of policy normalization. When

it is clear that they will begin slowing the rate of asset purchases --

which I think will have to be fairly soon, although not necessarily

this year given that they did not do it in September -- the next

obvious question will be how quickly the rest of the unusually easy

policies will be unwound, and what the broader 'exit strategy' will

look like. The last time they spoke about that was in 2011 and its

pretty obvious that what they said then is no longer an operativestrategy. They will need to say something about that at least by the

time that they start tapering, because at that point it will be very

clear that we are no longer in a period of just staying the course.

But a likely reason not to make big statements right now is of

course the imminent hand-off of the Chairmanship in January.


6/17

El



Kris Dawsey of the GS US economics team

addresses the September 18 taper head-fake,

the future of forward guidance, and Yellen

At the September FOMC meeting, the Fed unexpectedly decided

not to reduce the pace of its asset purchases. This followed

several months of the Fed seeming to communicate that it was

setting up for a taper. The surprise decisionon top of surprisingly

dovish signals on the forward path of the fed funds

rateprompted an 18 basis point drop in the 10-year Treasury yield

from just prior to the announcement to the afternoon close. In this

(relatively new) era of the Fed and other central banks heralding

transparency and going to ever-greater lengths to communicate

their intentions, the key question is: why was the market caught

so off guard?

What not tapering looked like

US 10-year treasury yields, %

Source: Bloomberg.

There are at least a couple of potential explanations. First,

conditions had deteriorated heading into the meeting. Data

surprises were generally negative in August and the first part of

September. Although the market could also observe this

deterioration, it was faced with the challenge of discerning the

degree to which the Fed was focused on the weaker latest month

or two of data, versus the cumulative improvement in the datasince QE3 was introduced, as some communications had

emphasized. As it turns out, the Fed seemed to place more

emphasis on the former than the market expected, with the

meeting minutes explicitly singling out the disappointing July and

August payroll reports as a cause for concern. Worries about the

upcoming fiscal deadlines and potential downside risks to the

economic outlook also seemed to grow, with the situation arguably

just beginning to look more uncertain in the days leading up to the

meeting.

Second, in the context of growing unease about the cyclical

indicators and the fiscal situation, the fear that a decision to taper

might further tighten financial conditions and in particular,

increase mortgage rates apparently gained greater prominence.This concern was amplified by the fact that the Committee was

unable to come to an agreement at the September meeting on

how they might enhance or clarify forward guidance to offset the

potentially more hawkish signal of tapering. The possibility that

further forward guidance might not be as credible in light of the

upcoming transition in Fed leadership was also mentioned. On net,

some things had changed since the Feds earlier

communications, which the Fed seemed to give more weight

to than the market, but the Fed also seemed uncomfortable

following through with the expectations it had largely created

for itself amid the cyclical and market uncertainty.What next for guidance?

We expect the Fed to ultimately enhance its forward guidance

when it chooses to taper asset purchases, at this point most

likely at the March 2014 meeting.It is also possible that they

choose to adjust the guidance before tapering. Possibilities include

a clarification that the current threshold of 6.5% unemployment

that must be met to consider a shift in policy rates only applies if

the committee's near-term inflation forecast is at the target and a

lower threshold would apply if inflation remains below target, an

outright inflation floor, or an outright reduction in the

unemployment threshold. Such changes would be in line with

outcomes suggested by a number of Fed officials, includingBernanke himself at the last post-FOMC press conference. But

what Chairman Bernanke does or does not support is quickly

becoming less important in light of the imminent transition in Fed

leadership at the end of January.

The real question: Yellen

The real question is what will now-Vice Chair Janet Yellen support,

provided she is confirmed as we expect? We think that the

Yellen Fed will be similar to the Bernanke Fed in terms of its

overall policy stance. Janet Yellen has spoken very favorably of

the value of forward guidance in the past, calling economic

outcome-based thresholds for raising rates a major

improvement. As head of a Fed committee on revamping

communications policy, Yellen has shown herself to be a fan of

increased transparency. Perhaps most importantly, she has on

several occasions shown simulations of optimal monetary

policyillustrating the unemployment rate falling below the

current 6.5% threshold before rate hikes begin. For these reasons,

we think she will be supportive of enhancing forward guidance, if it

does not occur before she takes the helm at the March meeting.

It is also likely that Yellen will support reducing the pace of asset

purchases in measured steps, rather than rapidly, if for no other

reason than the likelihood that QE helps to enhance forward

guidanceas demonstrated by volatility in front-end rates

following the start of taper talk in Junealthough she has also

spoken favorably in the past about the efficacy of QE in its ownright.

DID YOU KNOW?

Although the rates market was caught substantially off guardby the FOMCs September 18 decision not to taper, the goldmarket seemed far less surprised by the decision. Gold priceshad risen steadily heading into the meeting consistent withmore dovish expectations that have historically lent support tothe metal, which is traditionally considered a store of value.Gold prices therefore saw a much more muted rally than didrates post the decision, helping to close the large valuation gapthat had opened up between the assets over the prior month(see page 13).

Kris Dawsey, US Economist

Email: [email protected] Goldman, Sachs & Co.

Tel: 212-902-3393

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September 18

FOMC Statement

The taper head-fake and whats next


7/17

El



Forward guidance explained

Responsible central bankers committing to be irresponsible

The goal of forward guidance is to steer market, as well as public, expectations about the future path of monetary

policy. This guidance can take many forms, including (1) an explicit forecast for future interest rates, which the

Riksbankand some other central banks publish; (2) a simple statement of an intention to keep interest rates low for

some unspecified period, such as an extended period; (3) calendarbased guidance that commits to keeping rates

low until at least a specific point in time; and (4) outcome-based guidance that establishes specific economic

thresholds that must be met before considering a shift in monetary policy, as has been adopted more recently by the

US Federal Reserve (in December 2012 ) and the Bank of England (in August 2013).

Calendar and threshold-based guidance are not necessary to achieve the goals of forward guidance. But these forms

of guidance can have an additional feature that weaker forms of forward guidance do not share: in publicly committing

to keep interest rates at their effective floor until observable parameters are breached, a central bank is voluntarily

tying its own hands and, in doing so, can provide additional stimulus.

The logic of such an approach comes from the fact that spending in the economy today depends partly on

expectations of both future real interest rates and future spending. Therefore, if a central bank can credibly commit to

maintaining low interest rates beyond the point where it would normally choose to raise rates, the expectation of such

irresponsibly dovish behavior in the future can help to stimulate growth today. The problem is that, given theconservative nature of central bankers, it is difficult for them to credibly commit to being irresponsible in this way: once

growth and inflation begin to rise, they will want to renege on their initial commitment and start to raise interest rates.

The public announcement of calendar-based guidance or thresholds can act as a disciplining mechanism to ensure

that they remain irresponsible in the future.

Central bankers and academics describe this as the optimal control approach to monetary policy choosing a

path for interest rates which best meets its objectives over several years as a whole (for the Federal Reserve that

means best fulfilling its dual mandate of full employment and price stability), even if this means committing to a policy

that is suboptimal at future points along that path.

The costs and benefits of adopting an optimal control approach to monetary policy is one that has been discussed

more extensively in the US than in Europe. And, indeed, Fed officials appear to have leaned more in the direction of

this approach than other central banks. In particular, the optimal control perspective has been discussed in a series of

speeches by Janet Yellen, the Vice Chair of the Federal Reserve who was recently nominated to succeed Chairman

Bernanke when he steps down in January 2014.

The accompanying exhibits simulate the differences for the economy under an optimal control path for policy and the

path projected by the FOMC in its September 2013 Summary of Economic Projections. Under the optimal control

approach the funds rate stays on hold for longer (until early 2016), unemployment falls more sharply and inflation is

allowed to overshoot the 2% goal temporarily.

* Based on the September 2013 Summary of Economic Projections.


Jari Stehn and Kevin Daly

Unemployment Rate Headline PCE InflationFederal Funds Rate

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8/17

El



Huw Pill, Chief GS European Economist,

discusses the concerns about forward

guidance that seem to be generally greater on

the European side of the pond

The Federal Reserve was an early and enthusiastic adopter of

explicit forward guidance for monetary policy. By contrast, the

leading central banks in Europe initially showed greater reluctance.

Indeed, for some time, the mantra of ECB President Mario Draghi

(and, before that, his predecessor Jean-Claude Trichet) had been

we never pre-commit on the future path of policy interest rates.

More recently, attitudes have evolved. Over the summer, both the

ECB and the BOE officially adopted their own forms of forward

guidance. But, crucially, European policymakers have been at pains

to point out that their guidance should be interpreted as a vehicle

for better explaining their existing policy framework, rather than as

a shift in the strategic framework itself.

In particular, European central banks have avoided giving the

impression that they would be prepared to hold policy rates

lower for longerthan would normally be expected, in an

attempt to ease financial conditions by flattening the yield curve to

a greater than usual extent. Such an approach has been advocated

by some as a way of obtaining additional monetary easing when

(short-term) policy rates reach their zero lower bound.

The objections

The main objection to the pursuit of such a policy is that it

would not be time consistent. In other words, once

macroeconomic conditions began to normalize for example, as

slack is eroded by stronger growth and inflation threatens to rise

the central bank would have an incentive to raise rates regardless

of its previous guidance in order to achieve its stabilization

objectives.

Two consequences could arise from the adoption of such a time

inconsistent approach. On the one hand, it may undermine the

effectiveness of the forward guidance program itself.Because

market participants understand that central banks will want to

renege on its promises in the future, they will not believe the

guidance offered at the outset. This lack of credibility implies that

market expectations will not be influenced by the announcement of

guidance, and therefore the desired flattening of the yield curve

and associated financial easing will not happen.

On the other hand, should the monetary authorities actually deliver

policy interest rates that were lower for longer than normally

required to stabilize the inflation outlook at target, it is natural to

expect that the inflation rate will rise, possibly to undesired

levels.Of course, this may simply represent a short-term

overshoot of the inflation objective. But should longer-term inflation

expectations be destabilized in the course of the overshoot, the

deviation from target is likely to prove more persistent and more

costly to correct.

Central banks in Europe may be particularly concerned about these

issues. For example, given the specific institutional context in the

Euro area, the monetary policy decision making process may find it

more difficult to follow through on guidance offered in the past.Moreover, in many European countries with a recent history of

more elevated inflation, the perceived threat of destabilizing longer-

term inflation expectations could be greater than in the United

States, where the Federal Reserve has built up a strong reputation

over many years.

Related concerns about forward guidance stem from the difficulties

policy makers may face in emphasizing the conditional nature of

that guidance. Markets could interpret forward guidance as a

concrete and irrevocable commitment by the central bank

regarding its policy interest rate path.But central banks need to

retain some discretion to vary policy rates (both immediately andinto the future) as circumstances change unexpectedly (or, in

economic jargon, shocks occur). It is this conditional response to

shocks that imparts monetary policy with its stabilizing properties

for the economy.

Afraid of the consequences in terms of market reaction and/or

volatility that could derive from a central bank failing to deliver on

its (mis)perceived unconditional commitment via forward guidance,

policy makers may cling to the satisfaction of previous guidance,

even when changes in economic considerations dictate otherwise.

This will lead to policy mistakes. Forward guidance can box a

central bank in to an inappropriate policy.

Thresholds not a cure-all

The Federal Reserve has tried to manage this concern by

emphasizing the conditional nature of its forward guidance through

announcing economic thresholds that would trigger a potential re-

evaluation of the guidance and the interest rate decisions that

derive from it. In particular, the Fed has announced thresholds in

terms of the unemployment rate.

But this is not a cure-all. Concerns about this approach stem from

two sources. First, it is unlikely that any single summary

variable be it unemployment or another indicator can

adequately capture the potential impact of all the factors that

should trigger a reassessment of the forward guidance policy.

For example, in practice the Federal Reserve has faced some

challenges arising from fluctuations in the US labor marketparticipation rate, which have reduced the unemployment rate

more rapidly than they may originally have expected.

Second and, in the eyes of many European monetary policy

makers, more importantly introducing thresholds for real

variables such as unemployment can distract the attention of

both policy makers and financial markets from the central

banks underlying mandate to maintain price stability.

Nothing new

Central banks throughout the world recognize that expectations of

future settings of policy interest rates exert a powerful influence

over financial conditions and thus over the economic outlook.

Guiding interest rate expectations is therefore a crucial arguably, thecrucial channel of monetary policy

transmission in most modern views of how the economy works.

As such, all central banks are engaged in forward guidance,

understood as efforts to steer interest rate expectations. Forward

guidance is therefore nothing new: the issues raised by recent

policy experience concern the meansto steer interest rate

expectations, rather than the desirability indeed, necessity of

doing so. And the adoption of more explicit communication to steer

rates, potentially in ways that deviate from normal behavior once

the economy reaches the zero lower bound for nominal rates,

remains justifiably controversial.

Huw Pill, Chief European Economist

Email: [email protected] Goldman Sachs International

Tel: +44(20)7774-8736

Forward (mis)guidance?


9/17


10/17

El



Robin Brooks of the GS Markets/Economics

teams finds that the jury is still out on whether

words can be as credible as deeds

Federal Reserve Chairman Ben Bernanke argued in July 2013 that a

reduction in asset purchases (tapering) could be offset via forward

guidance, so that the overall level of accommodation, and in turn,

stimulus to the economy, would remain unchanged. But for much

of the rest of the summer, US interest rates moved higher. This

was not the first time markets reacted in the opposite direction of

that intended by central banks attempting to stimulate the

economy through words. As major central banks increasingly

adopt forward guidance approaches to monetary policy, this

unexpected behavior raises the key question: can words really

equal deeds? A look at the recent US and Canadian experiences

suggests (at best) the jury is still out.

The (US) background

The Fed has been experimenting with different forms of forward

guidance for some time, all with the aim of convincing the market

of future Fed behavior in order to boost spending and investment

today. In the December 16, 2008 post-meeting statement, the Fed

said that the funds rate target would be cut to its effective lower

bound and was expected to be kept at this level for some time.

On March 18, 2009 this was strengthened to say that conditions

were likely to warrant a low funds rate for an extended period. In

2011 the Fed started experimenting with calendar guidance,

which committed to low rates over a specified period of time; the

horizon of this period was then extended twice. On December 12,

2012, the Fed shifted to using thresholds, noting that the current

exceptionally low level of interest rates would be appropriate as

long as the unemployment rate remains above 6.5%, inflation

remains below 2.5%, and longer-term inflation expectations remain

well anchored.

Word choice matters, at least sometimes

Have words worked? Intuitively, if forward guidance is credible,

US interest rates (especially in the front end of the interest rate

curve, which the Fed should influence the most) should not be

responsive to data surprises because the Fed has committed to a

certain rate path. Using this measure, calendar guidance

largely worked; front-end interest rates showed almost no

sensitivity to data surprises during the period of calendar

guidance.

But the news is not as good for threshold guidance. The

responsiveness of front-end and especially longer-dated rates

to data surprises rose sharply with the switch to thresholds.

Some of this may have been intentional - low rate volatility under

calendar guidance may have been seen by the Fed as working too

well, making the market too complacent to cyclical conditions and

the possibility of rate hikes, which could give rise to financial

imbalances. But the extent to which it happened and the fact that

the sensitivity to data rose back to pre-crisis levels may ultimately

have played a role in the Feds surprise decision not to taper, which

abruptly sent rates lower across the curve. In the end, deeds

were stronger than words, and forward guidance at least fornow is back to the drawing board.

Thresholds on, data sensitivity up

Sensitivity of changes in 3-year yield 2-years forward to positive US

MAP surprises, bps (higher value = higher sensitivity)


The Canadian Experience

The Bank of Canada (BOC) experimented with forward guidance in

the aftermath of the global financial crisis. On April 21, 2009, the

BOC cut its policy rate to what it considers the effective lower

bound (25 bps), using up its conventional monetary policy tools. In

conjunction with that, it provided calendar guidance, committing

to keep rates at their low level until the end of the second quarter

of 2010, conditional on the inflation outlook. This language was

kept until March 2010, with the BOC raising its policy rate to 0.5%

in June of that year.

The yield curve for Canadian rates flattened somewhat on the

announcement, as uncertainty over the direction of future

monetary policy lessened. However, better-than-expected data

in the United States in June of 2009 prompted Canadianinterest rates to rise, as markets started looking to the escape

clause of the BOCs conditional commitment. In this case, it

seems words (no matter what the choice) were not enough.

Forward guidance: Derailed by data

%

Source: Bloomberg.

Deeds over words

But for the US and Canadian experiences the counterfactual is

what matters. While in absolute terms interest rates moved higher

seemingly more driven by data than by words they may still

have been lower than without forward guidance. As such, the jury

is still out on how well forward guidance works. What is clear,though, is that markets prefer deeds to words.

Robin Brooks, Senior Markets Economist


Tel: (212) 902-8763

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January 25, 2012

calendar guidance

December 12, 2012

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Data sensitivity above the 2-year tenor fell sharply withthe Feds introduction of calendar guidance (Aug. 9, 2011

and Jan. 25, 2012) but then has been rising sharply

above what is normal wi th the shift to thresholds on

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Can words really equal deeds?


11/17

El



Implications of central bank communication

FXThomas Stolper& Team

Unconventional monetary policies need to be considered as extensions of traditional monetary policy. In that

sense, we would expect a dovish surprise to lead to currency depreciation and vice versa. The problem with non-traditional policies is that they are not as easily comparable across countries as traditional

policy rates, generating substantial uncertainty. Market participants have long looked at longer maturity interestrates to compare cross-country differences in non-conventional policies. But these relationships also change.Calendar guidance introduces less volatility into bond yields than threshold guidance, for example.

Often it appears that gauging the distance from the stated policy target gives the best indication of central bankstance. Currencies are likely to weaken when their central banks undershoot their individual target by alarger margin than others.

RatesFrancescoGarzarelli& Team

Although forward guidance has evolved significantly since its introduction by the Fed around 2008, behind italways laid an attempt to keep expectations of short term rates anchored around zero for a sufficient period oftime into the future.

During its first implementation in the form of calendar guidance, rate expectations became increasinglyanchored to their lower bound, to the point that long-term rates were unresponsive to macro developments andterm premium was eroded across the curve given the low volatility.

The implementation of threshold guidance has proven to be more challenging, in particular as it is seen by themarket as intrinsically intertwined with QE. Proof of this was the sharp rates sell-off during the summer drivenby the expectation of an earlier policy rate hike based on the assumption that the FOMC was going to taper inSeptember and the rally once the decision was delayed.

More recently, economic data have been mixed and markets have pushed out expectations for the first hike,with implied volatility moving down to levels last seen around Bernankes testimony before Congress in May.

We believe that markets will not unwind the term premium now built into the yield curve and that 10-yrgovernment yields will smoothly drift higher towards our year-end forecasts of 2.75% for US Treasuriesand 2% for German Bunds. We forecast a further sell-off in 2014, as stronger expected growth pushes theeconomy towards the Feds thresholds, influencing expectations of rate hikes.

CreditCharlieHimmelberg

& Team

We think that forward guidance is a more effective stimulus to credit risk appetite and credit creationthan QE.

But tapering is not tightening if it is accompanied by improvements in forward guidance.

Based on our conversations with investors, we think that the market is giving this point too little weight, payingtoo much attention to rates risk and QE tapering, and not enough attention to the likelihood of more dovishtailwinds from forward guidance.

We are therefore more bullish than the market on headline risks from the Fed over the next few quarters.

More generally, we think credit remains fairly valued. Credit quality remains strong, and the above argumentsplus the prospect of better growth means that the outlook for risk-taking remains favorable.

EquityDavid Kostin(US)

Kathy Matsui(Japan)

Tim Moe

(Asia ex-Japan)

Peter Oppenheimer(Europe)

Helen Zhu(China)& Teams

Quantitative easing (QE) has supported global equity markets in recent years, and everything else equal thepotential tapering of asset purchases is likely to be a headwind across stock markets. However, DM equitiesshould still be able to perform in an environment where policy is tightened as a response to a better DM growthoutlook, at least when measured over slightly longer horizons.

Equity investors are concerned that forward guidance will be an imperfect substitute for QE, thoughultimately the fundamental linkage of these policies to the equity market is through interest rates, which may beanchored by forward guidance. Our US Economists believe forward guidance is a more effective tool for drivinggrowth and keeping rates low.

In the US we have found Fed commentary to be as impactful to equity returns as changes in policy rates. Ouroutlook for continued easy monetary policy via low rates and forward guidance supports pro-cyclical areas of themarket such as growth, weak balance sheets and low return on capital. Communication that implies tighteningcould have the opposite effect over shorter time horizons.

Looking across the global equity landscape, EMs have generally responded more negatively to a potentialtightening of US policy, especially those with significant current account deficits. On the other hand, thenormalization of unconventional policy in the United States is likely contingent upon an economic growthrecovery, which in turn would bode positively for global equity markets.

CommodityJeff Currie& Team

The impact of central bank easing on commodity markets has likely been limited; it is the pace of economicactivity and not forward expectations of such activity that drive physical commodity markets.

The exception is gold, as gold and US real interest typically move with a strong inverse correlation. Thus, Fedeasing has been broadly supportive of gold prices.

But the pass through of future easing on rates and ultimately gold prices is likely shifting; as threshold forward

guidance is inherently data dependent, the correlation between gold and economic activity will likely return to itspre-QE higher level. Under our economic forecast for above trend growth in 2014, we forecast further declines ingold prices next year.

Over the long term, the expansion of the Fed balance sheet through QE could spur inflationary pressures,lending support to gold prices. But the substitution of QE for forward guidance may limit this potential upside.

Snapshot of our views


12/17

El



Jari Stehn of our US economics team

addresses the shifting preference towards

forward guidance (FG) from asset purchases

(QE), but the difficulty is in the disentangling

The Fed has used both asset purchases (QE) and forward

guidance extensively since reaching the zero bound for the federal

funds rate in late 2008. Initially, the FOMC viewed QE as a highly

effective tool in easing financial conditions and supporting the

economy. In 2011, for example, Chairman Bernanke argued that a

wide range of market indicators supports the view that the Federal

Reserve's securities purchases have been effective at easing

financial conditions. Over the last couple of years, however, it

appears that the committees view on the relative reliability of its

two unconventional tools has shifted. In 2012, for example,

Bernanke stressed in his Jackson Hole speech that both the

benefits and costs of nontraditional monetary policies areuncertain. This September, Bernanke stated that forward

guidance is actually the stronger, more reliable tool.

Bernanke speak

Source: Federal Reserve Board.

From QE to FG

We see two main reasons why the committees thinking might

have evolved toward favoring forward guidance. First, it appears

natural for the efficacy and costs of the two policies to changeover time. Bernanke said explicitly in 2012 that the costs and

benefits of unconventional policies will also vary over time,

depending on factors such as the state of the economy and

financial markets and the extent of prior Federal Reserve asset

purchases. A larger balance sheet, for example, would be

expected to make the effects of additional QE more uncertain.

Likewise, the effectiveness of using additional forward guidance

would be expected to depend on how far market pricing is from

the committees view on the path of the funds rate.

Second, a number of academic studiesincluding work

conducted at the Fedsuggest that the efficacy of QE has

fallen relative to forward guidance.Most notably, Michael

Woodfords presentation at last years Jackson Hole conferenceargued forcefully that forward guidance is a more powerful tool

than asset purchases. In addition, more recent studies of the

magnitude of QEs impact have produced estimates considerably

different from earlier studies, likely increasing Fed officials

uncertainty.

We agree

Our own research is consistent with the view that forward

guidance is a more powerful and reliable tool than asset purchases.

Specifically, our results suggest that a given change in long-

term Treasury yields is about twice as effective in easing

broader financial conditions when it comes through forward

guidance as when it comes through asset purchases.

Moreover, we found that the accuracy of these estimates is

notably higher for the effects of forward guidance than QE.

Forward guidance twice as effective

Days since policy action (horiz. axis);basis points (vert. axis)


These considerations were likely one reason for the committees

taper talk this summer. In particular, Chairman Bernanke arguedthat Fed communication was primarily about adjusting the mix of

instruments away from QE towards forward guidance.

Difficult disentangling of QE and FG

The subsequent sharp tightening of financial conditions, however,

suggests that it is difficult to cleanly separate the effects of QE and

forward guidance in practice. In particular, the sharp sell-off

suggests that the pace of QE can act as a signaling device for the

committees intentions for future policy and therefore affect the

credibility of its forward guidance. So, when the committee raised

the possibility of tapering, the market sold off sharply because

investors pulled forward their expectations for the date of the first

funds rate hike.

This interaction between QE and forward guidance supports

our expectation that the FOMC will not want to taper its asset

purchases until the recovery has gained momentum.Although

the uncertainty is considerable, we currently expect the committee

to taper at the March 2014 meeting under our economic forecast

and provided that the next round of fiscal deadlines will prove less

disruptive than the most recent set. If this assumption proves

wrong, and especially if there is another lengthy debt ceiling fight

that lasts until close to the March FOMC meeting, the tapering

decision could be delayed even longer.

Jari Stehn, Senior US Economist


Tel: 212-357-6224

2011 2012 2013

Bernanke, February 3, 2011:

"A wide range of market indicators supports the view that the Federal

Reserve's securities purchases have been effective at easing f inancial

conditions"

Bernanke, August 31, 2012:

"...both the benefits and costs

of nontraditional monetary

policies are uncertain"

Bernanke, September 18, 2013:

"We have asset purchases, and we

have rate policy and guidance about

rates. It's our view that the latter, the

rate policy, is actually the stronger,

more reliable tool."

0

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Forward Guidance

QE

Efficacy of QE versus FG


13/17

El



Lasse Holboell Nielsen of the GS European

economics team discusses lessons the ECB

can learn from the Scandinavian forward

guidance pioneers

Forward guidance is not a policy reserved for only extreme

situations. Indeed, well ahead of the global financial crisis and

before the zero lower bound of policy rates motivated some

central banks to explore the role of communication tools to achieve

further easing, Norways Norges Bank introduced a form of

forward guidance in 2005, while Swedens Riksbank followed soon

after in 2007.

Explicit but conservative

The Scandinavian central banks form of forward guidance is

among the most explicit in nature: both Norges Bank and the

Riksbank publish a policy rate path several times a year detailingthe level of the policy rate expected by the (majority) of the

Executive Board of the central bank over their forecast horizon

(around three years). In addition, the Scandinavian central banks

publish a range of economic forecasts, such as growth, inflation,

the output gap and the unemployment rate.

Although the form of forward guidance may be one of the most

explicit currently in place, the nature is more conservative: the

policy rate path is a conditional estimate of future policy rates -

based on the economy and market conditions not a commitment.

With no intention of attempting to tie their hands in the way that

Fed-style forward guidance aims to do by promising to keep rates

lower for longer than would normally be the case, Norges Bank

and the Riksbank maintain full discretion at all times. Forwardguidance in Scandinavia is therefore a pure communication tool

rather than an innovation in monetary policy strategy.

Shaping expectationsRiksbank style

%

Source: Riksbank, Goldman Sachs Global Investment Research.

Relevant for the ECB?

Scandinavian central banks lengthy experience with forward

guidance may be more relevant for the ECBs nascent forward

guidance than what one might immediately think.While theECBs style of forward guidance is rather vague, stating only that

policy rates will remain at current or lower levels for an extended

period of time, compared to the Scandinavian central banks

detailed policy rate paths, both the ECB and Norges Bank/the

Riksbank maintain full discretion of their policy rates at all times.

This is a crucial similarity. And with a shared fundamental

underpinning of forward guidance, the Scandinavian experience

may shed light on whether a more explicit form of forward

guidance by the ECB, while maintaining full discretion, might help

the ECB more effectively influence Euro area money market rates.

Gains from transparency despite discretion

A look at how past shifts in the Riksbanks published policy

rate path have impacted market pricing suggests that changes

to the policy rate path can be just as important to shaping

forward market pricing as changes to actual policy rates.

Because the form of communication at the Riksbank is so explicit,

this experience provides a likely upper bound to what can be

achieved (e.g., by the ECB) with a fully transparent form of forward

guidance that still allows for full discretion.

and Norges Bank style

%

Source: Norges Bank, Goldman Sachs Global Investment Research.

While we do not expect the ECB to adopt much more explicit

forward guidance, let alone to actually publish a policy rate path any

time soon, the Riksbank experience suggests that the ECBs

impact on market rates may be enhanced by increasing the

information available to the market regarding the ECBs view

of future likely policy developments.This could take the form of

increasing the length of the ECBs forecast horizon (currently only

between 1 to 2 years) or providing a greater account of the

Governing Councils deliberations.

DID YOU KNOW?As recently as two decades ago, most central banks activelyavoided communicating about monetary policy. According toJanet Yellen, the current Vice Chair of the Federal Reserve whowas recently nominated to succeed Chairman Bernanke:Montagu Norman, governor of the Bank of England in theearly 20th century, reputedly lived by the motto never explain,never excuse. The conventional wisdom among centralbankers was that transparency was of little benefit formonetary policy and, in some cases, could cause problems thatwould make policy less effective.Source: Janet Yellen, Speech: Communication in Monetary Policy,April 4, 2013.

Lasse Holboell Nielsen, Senior European Economist

Email: [email protected] Goldman Sachs International

Tel: +44(20)7774-5205

0

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2

3

4

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6

05 06 07 08 09 10 11 12 13 14 15 16

Actual policy rateExpected policy rate paths

Scandinavian monetary policy forward guidance is a

forecast, not a commitment, which has been important

given huge deviations in the past of actual policy rates

versus forecasted paths...but analysis shows that such

policy rate paths still affect market pricing.

0

1

2

3

4

5

6

7

04 05 06 07 08 09 10 11 12 13 14 15 16

Actual policy rate

Expected policy rate paths

Lessons from forward guidance pioneers


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Fed speaks, market listens

Average Absolute change in 10yr Yield around Fed Events (2001-12),

bp

Words, words, words

GS Fed Speak Tracker* vs. actual policy changes

Source: Bloomberg, Goldman Sachs Global Investment Research. * GS proprietary indicator that aims to capture the predictive content of Fedcommunication for the policy decision at the subsequent meeting.Source: Goldman Sachs Global Investment Research.

Forward guidance: Top of Mind!

Search interest, 100 = highest point of interest

Transparency pioneers (Inflation targeters*)

Date of inflation target* adoption

Source: Google Trends, Goldman Sachs Global Investment Research. Source: Federal Reserve Transparency and Financial Market Forecasts of Short-

Term Interest Rates, Swanson, February 9, 2004; Inflation Targeting: A New

Framework for Monetary Policy? Bernanke, Mishkin, January 1997.

Gold speaking the Feds language

Gold prices, $/oz (lhs); US 10-yr TIPs yield, % (rhs)

Questioning credibility

Japanese breakeven inflation reflected in inflation-indexed JGBs, %

Source: Goldman Sachs Global Investment Research. Source: Bloomberg.

0

1

2

3

4

5

FOMCStatement

Minutes ChairmanSpeech /

Testimony

FRBNYPresident

Speech

Vice ChairSpeech

GovernorSpeech

OtherPresident

Speech 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

-100

-80

-60

-40

-20

0

20

40

60

80

100

Policy Change (left)

Fed Speak Tracker (right)

Tightening

Easing

0

10

20

30

40

50

60

70

80

90

100

Fed issued

"extended

period"

guidance

Fed issued

"mid-2013"

guidance

Fed issued

"2014"

guidance

Fed issued"mid-2015"

guidance

ECB issued

"extended

period"

guidance

Fed issued

outcome-

based

guidance

BOE issued

outcome-

based

guidance

Fed issued

"for some

time"

guidance

Year Country

1990 New Zealand, Chile

1991 Canada

1992 Israel, United Kingdom

1993 Sweden, Finland, Australia

1995 Spain1998 Czech Republic, Korea, Poland

1999 Mexico, Brazil, Colombia

2000 Switzerland, South Africa, Thailand

2001 Hungary, Iceland, Norway

2002 Peru, Philippines

2013 Japan

* In practice, countries that adopted inflation targeting in the 1990s at the

same me s gn can y ncrease e amoun o n orma on a oumoneary po cy reguary reease o e pu c.

-0.90

-0.70

-0.50

-0.30

-0.10

0.10

0.30

0.50

0.70

0.90

1,100

1,200

1,300

1,400

1,500

1,600

1,700

1,800

Aug-12 Oct-12 Dec-12 Feb-13 Apr-13 Jun-13 Aug-13 Oct-13

Gold price US 10 year TIPS yield (right axis, inverted)

September FOMC

-0.5

0.0

0.5

1.0

1.5

2.0

2.5

Jan-12 Apr-12 Jul-12 Oct-12 Jan-13 Apr-13 Jul-13 Oct-13

Noda Cabinetresolution onlegislation for

raising theconsumption tax

Three-partyagreement on

raising theconsumption tax

Abe electedLDP leader

BOJintroduces 2%inflation target

Apr 4thunprecedented

easing

Growthstrategy

Finaldecisionon VAT

hike

Central bank communication in picsA special thanks to our US, Europe and Japan economics teams and our commodities team for most of these pics.


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Snapshot of our key forecasts

RevisionNotes

GS

Cons

GS

Con

s

GS

Cons

GS

Cons

GS

C

ons

GS

Cons

2013

2014

2013

2014

Global

2.8

2.8

3.6

3.5

-

-

-

-

-

-

-

-

-

-

-

-

US

1.6

1.6

2.8

2.6

1.38

1.32

1.40

1.27

1750

1

715

1850

1845

0.13

0.13

2.75

3.25

EUROAREA

-0.4

0.0

0.9

0.9

1.38

1.32

1.40

1.27

2950

3

010

3200

3250

0.50

0.50

-

-

GERMANY

0.6

0.5

2.0

1.7

1.38

1.32

1.40

1.27

-

-

-

-

-

-

2.00

2.50

CHINA

7.6

7.6

7.7

7.4

6.16

6.12

6.15

6.07

-

-

11000

-

6.00

6.25

-

-

BRAZIL

2.6

2.4

2.3

2.4

2.25

2.32

2.40

2.43

-

-

-

-

10.00

10.25

-

-

OnOctober10,werevisedour$/BRLforec

asttowardsa

strongerrealtoreflectagenerallymorecon

structiveglobal

backdropandEMFXtradingenvironment,b

uttheweak

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JAPAN

1.9

1.9

1.8

1.7

98

101

107

107

1250

-

1400

-

0.10

0.10

1.00

1.25

Withoutmuchintermsofnear-termcatalys

tsforaweaker

Yen,theriskisthatrange-tradingin$/JPYw

illpersist;we

thereforerevisedour$/JPYforecastsslight

lyloweron

October10.

Commodities

RevisionNotes

GS

Cons

GS

Con

s

GS

Cons

GS

Cons

GS

C

ons

GS

Cons

GS

Cons

GS

Cons

110

108

105

105

6600

-

6200

-

1300

-

1110

-

4.25

-

4.25

-

Note:Recentrevisionsmarkedinred;GDPconsensusisCo

nsensusEconomics,allotherconsensusisReuters,comm

odity12-moconsensusisReutersfor2014average.

Source:GoldmanSachsGlobalInvestmentResearch.

Brentcrudeoil($/bbl)

Copper($/mt)

Gold($/toz)

Corn($/bu)

3-mth

12-mth

3-mth

12-mth

3-mth

12-mth

3-mth

12-mth

$/BRL

$/BRL

BOVESPA

BOVESPA

$/JPY

$/JPY

TOPIX

TOPIX

EUR/$

EUR/$

DAX

DAX

$/CNY

$/CNY

HSCE

I

HSCEI

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EUR/$

SP500

SP500

EUR/$

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Eurostoxx50

Eurostoxx50

GDPGrowth(%yoy)

FX

Equity

Rates(%eop)

2013

2014

3-mth

12-mth

3-mth

12-mth

Policy

10

-yr


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Current Activity Indicator (CAI)

Measures the growth signal in the major high-frequency activity indicators for the economy. Gross Domestic Product (GDP) is auseful but imperfect guide to current activity. In most countries, GDP is only available quarterly, is released with a substantialdelay, and initial estimates are often heavily revised. GDP also ignores important measures of real activity, such as employmentand the purchasing managers indexes (PMIs). All of these problems reduce the effectiveness of GDP for investment and policydecisions. Our CAIs are alternative summary measures of economic activity that attempt to overcome some of these drawbacks.We currently calculate CAIs for the following countries: USA, Euro area, UK, Norway, Sweden, China, Japan, Hong Kong, India,Indonesia, Malaysia, Philippines, Singapore, South Korea, Taiwan, Thailand, Australia and New Zealand.

Financial Conditions Index (FCI)

Financial conditions are important because shifts in monetary policy do not tell the whole story. Our FCIs attempt to measure thedirect and indirect effects of monetary policy on economic activity. We feel they provide a better gauge of the overall financialclimate because they include variables that directly affect spending on domestically produced goods and services. The indexincludes four variables: real 3-month interest rates, real long-term interest rates, real trade-weighted value of the exchange rateand equity market capitalization to GDP.

Global Leading Indicator (GLI)

Our GLIs provide a more timely reading on the state of the global industrial cycle than the existing alternatives, and in a way thatis largely independent of market variables. Global cyclical swings are important to a huge range of asset classes; as a result, wehave come to rely on this consistent leading measure of the global cycle. Over the past few years, our GLI has provided earlysignals on turning points in the global cycle on a number of occasions and has helped confirm or deny the direction in whichmarkets were heading. Our GLI currently includes the following components: Consumer Confidence aggregate, Japan IPinventory/sales ratio, Korea exports, S&P GS Industrial Metals Index, US Initial jobless claims, Belgian and Netherlandsmanufacturing surveys, Global PMI, GS Australian and Canadian dollar trade weighted index aggregate, Global new orders lessinventories, Baltic Dry Index.

Goldman Sachs Analyst Index (GSAI)

Our US GSAI is based on a monthly survey of Goldman Sachs equity analysts to obtain their assessments of business conditionsin the industries they follow. The results provide timely bottom-up information about US economic activity to supplement andcross-check our analysis of top-down data. Based on their responses, we create a diffusion index for economic activitycomparable to the ISMs indexes for activity in the manufacturing and nonmanufacturing sectors.

Macro-data Assessment Platform (MAP)

Our MAP scores facilitate rapid interpretation of new data releases. In essence, MAP combines into one simple measure theimportance of a specific data release (i.e., its historical correlation with GDP) and the degree of surprise relative to the consensusforecast. We put a sign on the degree of surprise, so that an underperformance will be characterized with a negative number andan outperformance with a positive number. We rank each of these two components on a scale from 0 to 5, and the MAP score

will be the product of the two, i.e., from 25 to +25. The idea is that when data are released, the assessment we make willinclude a MAP score of, for example, +20 (5;+4)which would indicate that the data has a very high correlation to GDP (the 5)and that it came out well above consensus expectations (the +4)for a total MAP value of +20. We currently employ MAP forUS, EMEA and Asia data releases.

Glossary of GS proprietary indices


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Disclosure Appendix

Reg ACWe, Allison Nath

Documents

Goldman Sachs - A Guide to Guidance