Recalculating: Central bank roadmaps leave markets lost

August 8, 2013

Central banks in Europe have followed in the Federal Reserve’s footsteps by adopting “forward guidance” in a break with traditionBut, as in the Fed’s case, the increased transparency seems to have only made investors more confused.

The latest instance came as something of an embarrassment for Mark Carney, the Bank of England’s new superstar chief from Canada and a former Goldman Sachs banker. The BoE shifted away from past practice saying it planned to keep interest rates at a record low until unemployment falls to 7 percent or below, which it said could take three years.

Yet the forward guidance announcement went down with a whimper. Indeed, investors brought forward expectations for when rates would rise – the opposite of what the central bank was hoping for – although the move faded later in the day.

According to a money market trader:

The focus on… unemployment level in the UK at 7 percent, something which we have never really looked at before, has given us the possibility of just more volatility going forward. So rather than having a calming effect, the forward guidance from the UK and (BoE governor Mark) Carney has actually had the reverse effect, it’s created some uncertainty and volatility…

It’s just that the target set on the unemployment rate is quite close to where we currently are… had he set a slightly lower target then the market probably would have been a bit more comfortable with some forward guidance in that respect.

The UK unemployment rate was at 7.8 percent in June. By comparison, the U.S. unemployment rate stands at 7.4 percent versus the Federal Reserve’s 6.5 percent threshold for beginning to consider rate hikes.

The ECB’s experience with such policy goalposts, designed in part based on the research of Columbia University economist Michael Woodford, has been similarly disappointing. The central bank said in early July it would keep interest rates at a record low for an “extended period” and may yet cut further. But the move only managed to partially offset the fallout from the U.S. Federal Reserve’s plans to slow monetary stimulus.   

The message was further muddled at this month’s ECB meeting last week. ECB President Mario Draghi again affirmed interest rates will remain at record lows for some while to come and could fall further. But he was guarded when pressed on whether a rate cut had been debated. The apparent absence of this discussion contrasted with last month, when Draghi said the council had an “extensive discussion” about a cut before deciding to hold. 

According to a transcript of the Aug 1 news conference, Draghi said:

We actually only discussed forward guidance and within the confirmation of forward guidance you have an implicit decision about today’s interest rates. And the decision about forward guidance was, in fact, unanimous. By the way, it is not a decision in the sense that we take a decision each and every time. And here, I should say something. There was some discussion on whether we should repeat these words every time. I mean the words: “the Governing Council confirms that it expects the key ECB interest rates to remain…”. Now, because of an excess of prudence, we repeated them today. But we may not repeat them if we judge that you and the markets understand that a certain forward guidance is valid until further notice. So, in other words, we may not repeat the words if we are convinced that you and the markets understand that, if we do not say anything, it does not mean that we have changed our mind. It means that we stay with the same mind until we do change our mind! But that is an aside issue.

According to Elwin de Groot,  senior market economist at Rabobank:

This could inject more volatility in the market. Let’s assume he will mention (forward guidance) in the next few meetings… but then, for example, after a few months, they decide the market is fine and  to leave it out. Then, whether they like it or not, the market will probably react if they leave that wording out of their statement.

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