Markets may hate uncertainty, but it’s a fact of life, says Bank of Canada governor, Stephen Poloz, in a new paper; which concludes that while forward guidance from the central bank on interest rates is useful, it’s best used when rates are near zero.

The paper, which examines the role of uncertainty in monetary policy, indicates that Poloz believes that while forward guidance “removes a key source of uncertainty”, it can also generate market volatility when the market anticipates a change in guidance. “That does not invalidate the use of forward guidance, but it underscores that the lunch may not be entirely free,” it says.

The other potential downside of forward guidance, the paper says, “is that it is inevitably conditional on all the assumptions and forecasts that the central bank must bring to the table.” These conditions help create “a fragile market equilibrium in which every new data point can be interpreted as a potential caveat, and markets may need repeated doses of reassurance.”

“In short, forward guidance can become addictive for markets if it is overly precise or heavily weighted with caveats,” the paper warns.

“For these reasons, it is my belief that forward guidance should be seen as a useful tool in the central banker’s kit, but one that should be reserved primarily for use at the zero lower bound, as a form of additional insurance that the economy will return to equilibrium,” it says.

In the absence of forward guidance, the paper suggests that the market becomes more of a two-way proposition that is less vulnerable to unusual leveraging and volatile shifts in sentiment. “Essentially, the net effect of dropping forward guidance is to shift some of the policy uncertainty from the central bank’s plate back onto the market’s plate, a more desirable situation in normal times,” it says.

Indeed, Poloz notes in his paper that “the business of central banking is being reinvented in real time”, and at the Bank of Canada this is reflected in various efforts to embrace uncertainty in policymaking and its communications with the market.

“Some may see this evolution as an erosion in the accountability of central banking. Others may see it as an attack on economic models. Neither of those perspectives is valid,” the paper says.

“The idea is simply to inject a little more realism about uncertainty into the narrative, while trusting markets to wrestle with the data flow and deliver two-way trading. The idea is also to encourage our researchers to keep focusing on developing a practical understanding of how the economy works―an understanding that admits that rules around economic behaviour are not cast in stone, but are almost certainly subject to variation through time and events,” it concludes.