How central bankers have got it wrong

September 24, 2013

If you asked someone to list the chief qualities needed to be a good central banker I assume that the list may include: good communicator, wise, attention to detail, clear thinking, credibility, and good with numbers.  However, in recent months these qualities have been sadly lacking, most notably last week when the Federal Reserve wrong-footed the markets and failed to start tapering its enormous QE programme.

The market had expected asset purchases to be tapered because: 1, Ben Bernanke had dropped fairly big hints at his June press conference that tapering was likely to take place sooner rather than later and 2, because the unemployment rate has consistently declined all year and if it continues moving in this direction then it could hit the Fed’s 6.5% target rate in the coming months.

In the aftermath of the September Fed decision the markets, analysts and Fed commentators were lambasted for being too hasty and for trying to second guess the Fed. While I agree that the markets can get too hung up on the movements of the US central bank, I think that the criticism is unfair this time.

Ben Bernanke did not play fair last week, and mid-press conference shifted the tapering goal posts. He said that the unemployment rate was not a true reflection of the state of the economy (the markets said that at the time the Bank started linking asset purchases to an economic threshold), and instead said that the Fed would focus on broader measures of economic growth. This was backed up by the chairman of the Federal Reserve Bank of New York, who suggested that GDP would also play a part in informing the bank on the timing of tapering; suggesting that forward momentum in GDP is the new pre-requisite before tapering can begin, leaving the unemployment rate on the back burner.

The Fed is not the only central bank to have done this. The Bank of England have flip-flopped just like their peers the other side of the Atlantic. The BOE also has pledged to keep interest rates low until the unemployment rate declines to 7%, a mere 0.7% from where the rate is now. However, in a recent speech, BOE Governor Mark Carney said that if the unemployment did fall to 7% it would not automatically trigger a rate rise… Confused? So is the market.

The central banks set interest rates, interest rates are the price of money, and money is at the centre of the financial system. So rates – and where they are going – matter. Thus, the indecision from the Fed and the BOE has only made the markets, analysts and market commentators (me included) even more anxious. These days we don’t want to miss one data point or one speech for fear we get left behind in the great hunt for central bank clarity.

But maybe we are all searching for something that does not exist. The Federal Reserve Bank of St. Louis released a report last year on the effectiveness of central bank forward guidance.  It looked at early adopters of forward guidance including the Reserve Bank of New Zealand, central banks in Norway and Sweden and it also included the US Federal Reserve. Interestingly, this report found that forward guidance was only statistically significant at predicting where interest rates would be three quarters in advance for Norway and Sweden. In the US and New Zealand the report found there was no statistical link. The overall findings of the report found weak evidence that forward guidance increased the ability of market participants to forecast future short term yields, and no evidence of increased predictability of long-term yields. Thus, one the Federal Reserve’s own banks have reported that it is “difficult to see how forward guidance could significantly increase these central banks’ ability to control long-term yields”.

What is even more concerning is evidence that forward guidance may require the central bank to maintain its policy rate at the promised level, even when economic conditions have improved enough to warrant an adjustment in the policy rate. Thus, central bankers’ commitment to forward guidance could generate the next asset price bubble.

On paper it is easy to see the attractiveness of a central bank trying to guarantee that interest rates will stay stable for a period of time into the future, however, in reality, as the study finds, it isn’t possible. Instead, central banks end up confusing the markets by announcing economic thresholds that they don’t intend to stick to.

This brings me back to the start and the list of qualities one would expect a central banker to possess. Good with numbers and statistics – then why adopt economic thresholds only to ditch them when the data no longer fits your argument?  Credibility – forward guidance threatens to blast a hole in central bankers’ credibility both sides of the Atlantic.

But the real concern is that in a futile attempt to keep rates lower for longer than may be necessary or healthy, central banks may cause markets to panic, driving rates up at a rapid pace, which could hurt growth going forward. Central bankers are playing a dangerous game.

 

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