Back On Forward Guidance

I ran into a couple of interesting articles, and wanted to comment on them. The first is about forward guidance, the second is about a potential American diesel export ban.

The first article is “When central banks say nothing at all” by Stefan Gerlach. I will discuss the article after I do a review on forward guidance. I have written multiple times about this topic, but I was trying to be brief and skipped over the background.

Forward Guidance Background — The Rise of DSGE Models

If go back to “Old Keynesian” macro of the 1950s/1960s, the basic macro framework was understood as policymakers having two “neutral” high-level levers to manage the business cycle: monetary policy and fiscal. (There were other levers that were considered as well, such as quantitative credit policy, etc. However, such policies would require modelling the private sector in detail, and were thus beyond a “basic macro framework.”) It has been a long time since I looked at “old school” macro, so this article should not be considered a deep analysis of the history of economic theory.

Fiscal policy could be decomposed into tax rates and spending, but we could merge them into looking at deliberate changes to the fiscal balance. Monetary policy was based on the policy rate, i.e., the lever was raising or lowering the policy rate. Other interest rates (e.g., bond yields) might work their way into some models, but modelling bond markets was not a strong point of earlier models.

The problem with using the policy rate as a stand-alone “lever” to drive the economy is that once you deregulate bond markets, the expected path of short-term interest rates is a/the major determinant of term interest rates. In a country with fixed-rate mortgages, term mortgage rates matter a lot. (Some countries have mainly floating mortgage rates.)

There was a theoretical brouhaha in the 1970s about “time consistency.” Although this was mainly aimed at fiscal policy, monetary policy would be swallowed up by the same concern. The argument was that policymakers were attempting to fine-tune the macroeconomy by policy interventions — but those interventions were allegedly short-sighted, with politicians allegedly willing to create long-term inflation problems by excessively stimulating the economy for electoral political reasons. (Although the “boom-bust economy” was a serious concern, I am not entirely on board with some of the beliefs about it. It is certainly anachronistic. If we look at the post-Financial Crisis response, central bankers outside the Bundesbank were desperate to stimulate economies, while politicians were ramming through austerity policies. Very simply, comic book political analysis is not scientific just because you embed it in an optimisation problem.)

The turn to “neoclassical economics” was supposed to solve this problem — the economic model is built around the assumption that the economy is driven by the decisions of rational households who are optimising their utility over a a future time horizon. (Dynamic Stochastic General Equilibrium — DSGE — models.)

In a DSGE model, the economic outcome is not determined by the current level of the policy rate, rather the entire path from now to infinitely far in the future. So we do not care about what the central bank is doing at the next policy meeting, but every meeting in the future (including meetings that occur after the Earth is destroyed in a astronomic catastrophe of some sort).

Such models map onto fixed income pricing models, so they fit bond market stories better. But DSGE models are not exactly perfect. The obvious collision with reality occurred at central banks — central bankers want to know how to set the policy rate at the next meeting that they have to vote on, they have no idea what a “reaction function” means in practice.

Theory to Practice

I am not a fan of DSGE models, but they do point in one correct direction: to the extent that interest rates matter for the economy, what matters is what the beliefs are about the path of the policy rate, and not just the current level. The current level (and changes to the interest rate) do matter in what they signal about the central bank’s thinking.

The thing that is buried under libertarian nonsense about “let the markets determine interest rates,” short-term low-risk rates in fiat currencies are driven by the administered set of policy rates (central banks have a few that they can set, but they are normally set to be coherent with each other). Markets cannot move the administered rate, they can only adapt to it. (In currencies with pegs, the central bank can lose control of interest rates since it is pegging the currency exchange value.)

“Market rates” are invariably guesses as to what the policy rate will do in the future. If a central banker wanted to “let the markets determine interest rates,” they are setting rates based on guesses as to what they would do, and it is unclear how any useful information makes its way into that loop. In practice, a small cartel of dealers would manipulate interest rates to maximise their trading profits at the expense of everyone else. Although that might be an entertaining gambling opportunity, central bankers would end up being run out of town by enraged voters who want stable mortgage interest rates.

So we now get to “forward guidance.” In Ye Olde Days, central bankers stayed out of the limelight and typically said little about how they are setting interest rates. To the extent that they influenced market interest rates, hints about future policy were probably given through dubious “back channels.”

We now expect transparency from central bankers (i.e., not passing along tips to dealer friends), and we have an environment that selects central bankers by their ability to pontificate at press conferences.

So even if central bankers were hubristic with “forward guidance” in the 2010s, not offering guidance about future policy moves would require the entire central banking community to shut their yaps (and not position themselves for post-central banking jobs). Good luck with that.

Gerlach Article

Finally, back to the Gerlach piece. He wrote:

Without that signal, markets must rely more heavily on incoming economic data and comments by individual policymakers. But data are unavoidably subject to errors and revisions, and individual policymakers express their own views, not necessarily those of the full policy committee.

The shift away from all forms of forward guidance has two consequences.

First, markets can become too sensitive to incoming data, as illustrated by energy prices in the current environment. But knowing that energy prices have risen sharply does not necessarily mean that central banks will tighten policy dramatically. Without clearer guidance, markets must try to infer the answers themselves. They may price in more monetary policy tightening than is warranted.

Second, markets put excessive weight on comments by individual policymakers, which do not necessarily reflect the collective assessment of the committee. Without official guidance, even casual remarks in an interview can have an outsized impact on market expectations.

Although I may directionally agree with him, on his two listed consequences, I view things differently.

I will do with the second point first — do markets look too much at comments at individual policymakers? This is probably true, but I would argue that this really only matters for very short time horizons — e.g., what will happen in a meeting in three weeks? Through the magic of the embedded leverage of fixed income derivatives, one can make (or lose…) a lot of money betting on what is happening on a short horizon. Meanwhile, the entire central bank watching complex is obsessed about upcoming meetings — they are equivalent to the football games for football commentators. (You can write about whatever personnel shenanigans are going on between games, but what matters is what happens when the teams get on the playing field.)

But if you are concerned about longer-term instruments, whether the central bank hikes this week or even a couple of months later does not matter much for valuation (although it might for market timing). You have no choice but to look at data and ask yourself — is the central bank wrong about its forecast?

This gets back to Gerlach’s first consequence — that markets are too sensitive to incoming data. I would not view that as a problem, as my working assumption is that your focus should be on whether the central bank is wrong about the medium-term outlook. To the extent that others agree with this, bond yield volatility is not necessarily going to be that sensitive to central bank jawboning. That is, we know that they disagree about market positioning for rates in two years. However, we do not care, as we believe the central bank is wrong about the two-year forecast.

Diesel Export Ban?

The communist interventionists in the (checks notes) American Republican Party have been throwing around the idea of a diesel export ban. Patrick De Haan has an article with a self-explanatory title: “Why a Diesel Export Ban Won’t Fix Expensive U.S. Diesel Prices.”

Although I recommend reading the article, I would offer a short summary (in my own words).

1. American wholesale petroleum product prices are driven by global benchmarks (along with market-specific prices driven by logistics). Global diesel prices have risen more, but they taking the U.S. ones along for the ride. Attempting to cut off exports may not be able to fight pricing gravity.

2. The first problem is that the American petroleum market is a single geographical point. The United States is big. Diesel imports leave the gulf coast (Gulf of Mexico, that is), but the American Northeast imports their diesel/heating oil, and some northern states rely on those dastardly Canadians (possibly shipped over Lake Ontario). Blocking exports just creates a glut in Texas, and possibly cuts off the Northeast. The natural reaction of refiners would be to throttle output.

3. The next problem is that although consumer labelling of “gasoline,” “diesel,” and “heating oil” appears straightforward, actual refinery output exists on a continuum of products. Defining what products are hit by a ban is not easy. A narrow ban might easily be sidestepped.

There are also longer-term effects noted. Why build a new refinery if the commissars in the White House are going to intervene radically in the market every time the F-250 Super Duty™️crowd starts squawking? Will foreign countries rely on American exports once the American OPEC-wannabes start doing politically-motivated export embargoes?

This move is unlikely to be popular with Big Oil, so Chickening Out on the export ban remains a plausible outcome.

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(c) Brian Romanchuk 2026