Central Banks: Market Dependent

Central banks have added “forward guidance” to their bag of monetary policy tools since the financial crisis of 2008. The idea has been to guide financial markets in the desired direction without any surprises that might trigger financial turmoil.

Central bankers, particularly the ones at the Fed, have consistently declared that their policy moves will be “data dependent.” That makes forward guidance a very questionable exercise in practice because communicating it can very quickly degenerate into the old joke about economists, as first delivered by President Harry S. Truman: “Give me a one-handed economist! All my economists say, ‘On the one hand, on the other.’”

Making the situation even more amusing is that both the Fed and ECB have stated that their policymaking is also market dependent--on the third hand. That approach can easily (and can often) conflict with the data-dependent approach. Or at least it can be very confusing. In other words, there may be (and have been) plenty of times when no guidance might be better than forward guidance. Consider the following:

(1) Fed. There are certainly lots of two-handed economists at the Fed. Their two-handed guidance was most recently expressed in the 1/28 FOMC statement:

Based on its current assessment, the Committee judges that it can be patient in beginning to normalize the stance of monetary policy. However, if incoming information indicates faster progress toward the Committee’s employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.

What an amazing insight! The full minutes of the 1/28 FOMC meeting included the following punch line:

It was also suggested that maintaining the federal funds rate at its effective lower bound for an extended period or raising it rapidly, if that proved necessary, could adversely affect financial stability.

In other words, policy needs to be market dependent, i.e., it needs to factor in the likely market reaction to policy changes.

The minutes indicated that the FOMC may have some regrets about using the word “patient” in the previous statement and using it again in the latest one:

Many participants regarded dropping the ‘patient’ language in the statement, whenever that might occur, as risking a shift in market expectations for the beginning of policy firming toward an unduly narrow range of dates. As a result, some expressed the concern that financial markets might overreact, resulting in undesirably tight financial conditions.

Again, monetary policy is market dependent, not just data dependent.

Apparently, the FOMC is no longer amused by forward guidance and looking forward to ending it:

A number of participants noted that while forward guidance had been a very useful tool under the extraordinary conditions of recent years, as the start of normalization approaches, there would be limits to the specificity that the Committee could provide about its timing. Looking ahead, some participants highlighted the potential benefits of streamlining the Committee's postmeeting statement once normalization has begun.

In other words, there might be less guidance in the future.

(2) ECB. Following its meeting on July 4, 2013, the ECB’s Governing Council communicated that it expects the key ECB interest rates to remain at present or lower levels for an extended period of time. According to the ECB’s Monthly Bulletin:

The Governing Council’s expectation is based on the overall subdued outlook for inflation extending into the medium term, given the broad-based weakness in the real economy and subdued monetary dynamics. At the current juncture, forward guidance contributes to the ECB’s pursuit of its mandate of maintaining price stability effectively, within the framework and in full respect of its strategy.

At its June 5 meeting last year, the ECB cut the rate on its deposit facility for banks from 0.00% to minus 0.10%--the first time that a major global central bank has moved rates into negative territory. On January 22, the ECB announced a QE program that will start buying €60 billion per month in bonds during March until at least September 2016.

Last Thursday, for the first time ever, the ECB released the minutes of the Governing Council’s meeting. At the latest one on January 22, the members of the committee were aware that QE largely was priced into financial markets, and were concerned about the potential fallout if they didn’t deliver:

A large part of the very substantial financial price adjustment observed over recent weeks would most likely rapidly unwind if no monetary policy action were taken at the current meeting.

Policymaking is market dependent, not just data dependent.

(3) BOJ. Last Wednesday, Bank of Japan Governor Haruhiko Kuroda focused on the currency market’s reaction to QQE, which was introduced on April 4, 2013 and extended with QQEE on October 31, 2014. He ruled out additional near-term monetary easing in an effort to stabilize the yen, which may have fallen too much. It is down roughly 35% relative to the dollar since late 2012. That’s been great for exporters. But it has also depressed consumer spending by boosting import prices.

(4) PBOC. The People’s Bank of China is also watching the currency markets. Chinese officials, who have been pegging the yuan to the US dollar, must be increasingly concerned about the strength of their currency relative to the euro and the yen. This, along with weakening economic data, explains why the PBOC lowered interest rates last November and reserve requirements in January.

(Based on an excerpt from YRI Morning Briefing)