Seeing through the charade of forward guidance

This article appeared originally in Gulf News: link to original article

When the Fed first announced that it will start buying back bonds worth $85 billion (Dh312 billion) every month, the response from across the globe was comforting … relative to what was the norm at that time. As the dollar is the main exchange medium, and since the buy back can be easily financed with additional printing, there was no problem whatsoever.

The additional print run and the increased supply of dollars were good enough to trigger growth in emerging markets with currencies benchmarked against the greenback for valuation purposes. Not only that, the dollars used to purchase bonds from emerging economies encouraged their central banks to print more of their own currencies.

With more of these currencies made available, interest rates were lowered and financing for all purposes became possible. Emerging economies were growing at impressive rates and companies from all over the world were going to invest in them because of their competitive interest rates — all thanks to the special US stimulus plan.

And then a rumour was spread. The Fed was likely to drop the plan soon which will bring not only emerging economies but the entire world to a halt. The logic was straight forward. If the Fed were to continue printing dollars, these will carry absolutely no value in no time and the existing reserves will become worthless, eventually bringing the world to a halt and paving the way for a new crisis to settle in. And the dollars held by emerging currencies would turn worthless.

Then the currencies being printed against it would be worthless too. So the Fed did something else. It said: “Yes, we will drop the stimulus.” Then came back to say: “No, we won’t drop the stimulus… at least not yet.”


Forward guidance was counted on to keep the markets believing. This has more to do with “behavioural finance” or a more psychological side of economics. And even if the rumours were scary, it was enough for the markets to hear Bernanke say that the Fed will continue with the plan even if it wasn’t true.

Let people believe that you will keep encouraging their growth. And that nothing will be done to devalue the dollar too much or make investments in emerging economies less attractive than in the US, especially in its oil and gas sector.

Forward guidance doesn’t really work, at least not for long. We wouldn’t know, but countries selling back US held bonds will. Look around you.

The Indonesian rupiah, Indian rupee, Brazilian real, and Thai baht are not only losing value; but they are hitting record lows that they never got to before. The Turkish lira is now seeing signs of unwanted devaluation which neither Turkey nor its central bank would want to see happening after everything they did to protect the new lira.

The Turkish lira case might be a bit different though as the euro is used in transactions in Turkey. But you never know. The central bank over there has already taken actions to increase interest rates in order to promote the flight of capital into the country, and not the other way around.

Capital controls

India, on the other hand side, recently banned duty-free imports to restrict the need for dollars in terms of payments for these imports. And before that, India’s central bank imposed capital controls on transfers out of the country to limit personal remittances to $75,000 instead of $200,000. Will this work? We can wait and see.

However, and what I would like to find out in the coming few months, is whether or not this is similar to the attack on Asian currencies in 1997; when the whole scenario was exposed later on as a few hedge funds short-selling these currencies. Back then, one main hedge fund bet against the currencies and spread that they were going to drop.

With the drop actually happening, capital left the involved countries and the hedge fund made billions in the process. Now the thought that I want to leave you with is this: is it a genuine Fed case and should we measure risk based on each central bank’s exposure? Or is history repeating itself?

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