Forward guidance, to a certain extent, is nothing new. Previously it came as simple expectations, forecasts or projections, whatever you want to call them, but now it’s been given a more detailed title and is supposed to be the the holy grail for the markets. The question is whether the market is placing too much faith into words rather than the actions of central banks.

Former ECB international policy analyst, Marcel Fratzscher is questioning the validity of forward guidance. He writes that communication strategies with extensive promises and pre-commitments may have lured the market into a false sense of security.

He muses that central banks, while trying to warn about excessive risk taking may be fuelling that risk taking themselves.

In May, Bernanke issued an unusually stern warning about excessive risk-taking in financial markets. Yet investors have pushed equity indices to all-time highs, despite the feeble and uncertain recovery, while the VIX index, a proxy for investors’ perceptions of risk, fell to levels not seen since the boom years of 2005 and 2006.

Unfortunately, major risks and costs arise from over-reliance on communication strategies. Because the voice of central banks has become so dominant in financial markets, price movements have come to reflect responses to their statements and actions, rather than to changing economic and financial realities.

Another consequence of FW is that it negates the use of private sources of information which deprives the CB’s themselves of this independent information. This has led to independent sources reducing the data and analysis they do.

The most important consequence that CB’s face is one of loss of credibility. It’s one thing to issue range forecasts but another to put exact figures on economic data points for the purpose of monetary policy. As has been pointed out the, BOE have missed their inflation forecasts for nearly 4 years. Trust is a big thing with central banks and if targets are not hit when monetary policy has been enacted to hit those targets then the market will lose faith and forward guidance becomes nothing more than a broken promise.

Fratzscher says that rather than put explicit numerical targets on the economy they need to communicate more clearly and let the market decide the balance of risk and reward.

It’s an interesting read from the president of the German institute for economic research and certainly raises some questions.

We hear plenty of talk about what tools are in the central banks tool boxes but will the market reach a point where it decides it wants to see the tools for itself?

Are central banks hiding behind forward guidance because they don’t have the ammunition to combat further risks? For example, what real policies does the ECB have to target falling inflation with rates already so low?

So do you have faith in the central banks or are they digging themselves a big hole?