The Bundesbank in its heyday back in the 1980s took pleasure in wrong footing the markets with unexpected changes in interest rates. To central bankers of the current generation such behaviour would be regarded as outrageously uncouth and ill-judged. They recall with horror experiences such as the bond market rout of 1994 when an unexpected hike in interest rates by the Federal Reserve was reckoned to have inflicted notable damage on the US economy.
There followed a long period in which the Fed, under the chairmanship of Alan Greenspan, managed market expectations with extreme delicacy. This culminated in the experience between 2004 and 2006 when the Fed raised rates by just 0.25 per cent no less than 17 times. This morally hazardous spoon feeding of the markets facilitated a credit bubble that led to the credit crunch of 2007 and the subsequent financial crisis.
The response has not been to abandon spoon feeding, but to make it more sophisticated. In the current period of unconventional central banking measures we now have forward guidance, whereby policy makers pre-commit to a trajectory in the hope this will lower borrowing costs. The risk in such guidance is that people conclude the economy is weaker than previously thought so a discouraged private sector reduces its spending.
Policy makers have tried to overcome this difficulty by specifying the economic indicators that will dictate their future moves, an approach known in the jargon as state-contingent threshold guidance. Fed chairman Ben Bernanke has provided the most conspicuous example of the genre by tying any retreat from the Fed’s asset purchasing programme to particular labour market and inflation indicators. Yet when he offered a tentative statement about the Fed’s intentions on reducing the rate of asset purchases,bond and stock markets swooned across the world. Why such an extreme reaction?
Part of the explanation relates to market structure. Henry Maxey of the Ruffer fund management group points out that the intermediation capacity of the financial sector has been significantly reduced since the start of the financial crisis.
Because of balance sheet concerns and regulatory pressure, banks are less able to take on big inventory positions to buffer flows. At the same time, he adds, the size of global fixed income markets has grown from around $40tn to $100tn over the past 10 years. This is a destabilising combination, further exacerbated by a hedging dynamic whereby the need to hedge interest rate risk by selling bonds increases as interest rates rise. So selling begets selling. The result is an extreme over-amplification of marginal changes in US monetary policy.
The combination of quantitative easing and the spoon feeding process is also unhelpful. Since the onset of fiscal austerity, central banks have taken on responsibility for the real economy as opposed to their traditional mandate to address inflation. Market expectations of the central banks are pitched too high. And because markets are so fragile there is a risk that central bankers are over-communicating policy, all of which leads to excessive gyrations whenever a policy maker hazards an anodyne statement.
In fairness, it is very difficult to communicate forward guidance, which is why so many statements in both the US and Europe have been botched. Consider the European Central Bank’s recent decision to abandon its aversion to pre-committing on future interest rates. ECB head Mario Draghi said interest rates would be maintained at or below their current level for an “extended period”. The definition of an extended period was left unclear. And when ECB executive board member Jörg Asmussen came close to clarifying it, statements had to be put out to declare that Mr Asmussen had not intended to give guidance on the extent of the extended period. Ambiguity and confusion were probably inevitable because of Mr Draghi’s need to secure the support of both ECB doves and hawkish northern Europeans for the controversial policy.
This took place against the background of a fire fighting operation in the US. After the market swoon Fed governors sought to explain that the pace of bond purchasing would be dictated by the economic outlook, not the calendar, and that as long as bond buying continued it would be adding monetary policy accommodation even at a lower level of purchases.
I vividly recall in the early 1970s overhearing at a party the head of public affairs at the Bank of England explaining that his role was to keep in contact with the media and ensure he conveyed nothing of significance. We cannot go back to that. But where transparency is concerned, it is possible in markets to have too much of a good thing.
The writer is an FT columnist