LIVE MARKETS-For, and against, forward guidance

Thanks in large part to new Fed Chairman Kevin Warsh, a long-standing debate about central bank communication and forward guidance has been reignited. But is one approach to forward guidance actually better than the other?

Neil Shearing, group chief economist at Capital Economics, took a look at the pros and cons.

The "lighter-touch" approach to forward guidance, Shearing said, has a lot of overlap with what has been dubbed the "Maradona theory" of central banking. Without going into the analogy too much, "the idea is that central banks can sometimes achieve the desired tightening or loosening in financial conditions simply by shaping expectations, without actually changing interest rates."

That approach can create some problems though, Shearing said, as markets at some point will test the central banks' resolve.

"If policymakers repeatedly hint that rates will rise but fail to deliver, investors will begin to doubt their commitment. Inflation expectations may drift higher and currencies may weaken, forcing policymakers to act anyway," Shearing said.

Now for the other end of the spectrum: strong forward guidance. One example of this, Shearing notes, is from 2013, when the Bank of England vowed not to raise rates above 0.5% until unemployment fell to 7%.

But, "its decision to make interest rate hikes conditional on a fall in the unemployment rate was ultimately undermined by structural changes in the labour market, which caused unemployment to fall without generating the wage pressures and inflation that policymakers had expected."

Markets eventually focused more on wage and inflation data than unemployment figures, and kept pricing in very loose monetary policy even as unemployment eased, Shearing explained.

"This is a classic example of Goodhart’s Law: once a particular measure becomes the target of policy, it stops being a reliable measure," he said.