As financial markets come to terms with the end of cheap money being pumped into the system, central bankers must learn again how to use a more subtle but effective policy weapon: words.
Massive asset buying programmes and drastic interest rate cuts have stabilised the world’s economies following the global financial crisis but central bankers are starting to put their big policy guns away.
As they shepherd economies back to full health central bankers will instead need to choose their words carefully to manage expectations about future policy and avoid any damaging overreaction or misinterpretation by markets.
Communication is becoming such a policy focus that U.S. Federal Reserve Chair Janet Yellen, European Central Bank (ECB) President Mario Draghi, Bank of Japan Governor Haruhiko Kuroda and Bank of England Governor Mark Carney are meeting in Frankfurt on Tuesday to discuss how central banks should speak.
“Once the asset purchase programme is tapered the ECB will have to use its guidance on rates as the main policy instrument,” an ECB Governing Council member, who asked not to be named, said.
Part of the problem now is that central bankers just keep talking. Fed governors talk on an almost daily basis, Kuroda speaks frequently and some of the ECB’s 25 rate-setters appear to live a life of their own, sometimes giving speeches at odds with the European central bank’s main policy lines.
Last Thursday, eight European Central Bank policymakers, including five board members, spoke publicly but there was no major policy glitch that needed addressing specifically and few of the speeches carried any significant policy message.
In the United States, a survey by the Brookings Institute think-tank found that two-thirds of Fed watchers wanted governors to speak less frequently and over half wanted Yellen to speak more instead to streamline and focus the message.
Interest rates are expected to stay below historic averages for years, if not a decade, so the scope for actual rate changes has diminished and promises about future policy will play a bigger role in guiding markets, central bankers say.
The Fed estimates that neutral interest rates are 2.75 percent, down from 4.25 percent before the crisis, but current rates are still less then half this despite four rate rises by the Federal Open Market Committee (FOMC) since the end of 2015.
“With a low neutral federal funds rate, there will typically be less scope for the FOMC to reduce short-term interest rates in response to an economic downturn, raising the possibility that we may need to resort again to enhanced forward rate guidance and asset purchases to provide needed accommodation,” Yellen said last month.
The ECB is in an even more precarious position. It may end its 2.55 trillion euro (£2.27 trillion) asset purchases next year but will still be far from raising interest rates.
That too will leave its “forward guidance” – a pledge to keep rates low until well after the bond buying ends – as the chief tool to guide long-term interest rates.
While central banks have often relied on guidance as a policy tool, communication flops during the post-crisis normalisation process have been aplenty.
In 2013, the Fed’s suggestion that asset purchases might be coming to a close caused market mayhem. Analysts say the so-called taper tantrum probably ended up prolonging the U.S. bond buying programme.
Draghi’s speech in Sintra this year, which suggested that tighter monetary policy might be on the cards, resulted in such a big market sell-off that the eventual policy change was considered relatively mild.
Carney has also had his run-ins with words as his guidance on the path for interest rates was repeatedly knocked off course by surprises in the economy, prompting one lawmaker to call him an “unreliable boyfriend”.
The challenge for central bankers now is to nuance their communication to chart a path for long-term rates in a very low interest rate environment – and also start to explain what a new policy framework would look like if another crisis emerges.
“That comes with a number of challenges that have not been fully addressed,” said Frederik Ducrozet, an economist at Pictet Wealth Management said. “Forward guidance to me is too short an answer.”
“What’s the new monetary style? Will there be a regime shift to some sort to some sort of nominal GDP (gross domestic product) targeting? Do they want to use the balance sheet as a normal tool?” Ducrozet said.
For now, the Bank of Japan is coming under pressure to start discussing how it will eventually end its prolonged period of ultra-easy monetary policy.
Kuroda has so far rejected that demand, even though he has recently suggested that the Bank of Japan could tweak monetary policy before achieving its inflation target.
The day of reckoning is also coming for the ECB. It has learned from the mistakes of others and kept markets calm by promising low rates until “well past” the end of its asset buying programme.
But some investors say this time frame is too vague and needs to be refined.
Indeed, some argue that the ECB’s decision to extend it’s bond buying programme by nine months to September 2018 was really designed to push back expectations of a rate rise, given the stimulus won’t be that significant.
“Doesn’t the bank have a credibility issue when a its pledge is not enough?” another ECB Governing Council said.
Source: Reuters (By Balazs Koranyi, Additional reporting by Francesco Canepa, Leika Kihara, William Schomberg and Howard Schneider; editing by David Clarke)