Glasnost must be embraced by central bankers

January 1, 2014 10:47 am

Glasnost must be embraced by central bankers

By Julian Callow

With the intensification of the financial crisis in 2008, central banks cut rates sharply and rapidly ran into the zero interest rate bound, necessitating a recourse to non-conventional measures.These took three forms: large-scale asset purchases (quantitative easing), exceptional liquidity provision and forward guidance on policy rates.

Such measures were important in supporting recovery via a marked improvement in financial market conditions. The UK experience – growth so far in 2013 of 1.8 per cent – offers hope of life after QE, though UK conditions remain supported by the massive QE still being carried out by the US Federal Reserve and the Bank of Japan.

But the sharp rise in US real interest rates since May implies that the US bond market is already anticipating an end to QE in 2014. With central bank liquidity support also being scaled back in the US and Europe, this leaves forward guidance as the principal remaining non-conventional policy tool.

‘Our reaction function’

As noted by Bank of England deputy governor Charles Bean, forward guidance is intended to “clarify our reaction function and thus make policy more effective”. This is a useful description of forward guidance more generally. The monetary committees of the Fed and the BoE have aligned forward guidance around a threshold for the unemployment rate (a necessary but not sufficient condition for a rate increase), while also setting out their views on the interest rate path consistent with achieving their remits.

In contrast, the European Central Bank’s formulation of forward guidance is less clear-cut. The governing council expects policy rates to “remain at present or lower levels for an extended period”.

Forward guidance, and more open communication, seems likely to stay a core part of central banks’ tool kits. It is seen as an extension of effective communication, contributing to reduced uncertainty and to better traction in the transmission of monetary policy.

Forward guidance offers policy makers scope to exert influence over the level and volatility of the yield curve within the framework of “conventional” monetary policy just as non-conventional policies (asset purchases and exceptional liquidity support) are set to wane. Effective forward guidance is important for four reasons.

First, despite deleveraging in recent years, gross leverage ratios for the non-financial private sector in the US, UK and parts of Europe are still high by historical standards. This implies sensitivity to changes in interest rates for those sectors with significant exposure to variable rates.

Second, prior episodes of moving from a low policy rate to a “normal” rate have been accompanied by significant market volatility and a general tendency in the bond market to over-predict the extent of future tightening.

Third, interest-rate normalisation is taking place amid unprecedented low policy interest rates alongside vast non-conventional operations, the consequences of which are not well understood. Therefore, central banks need to pay especially close attention to clear communication of their reaction function.

Fourth, central banks are uniquely placed to estimate and publish an appropriate path for monetary policy. This underscores that they must aspire to be transparent in their analysis and continue to contribute to the understanding of the implications of monetary policy and of macroeconomic analysis. This brings with it a heavy responsibility in terms of fostering debate and acknowledging the uncertainties around any macroeconomic and interest rate projection.

New forms of guidance

In 2014, central banks will probably need to develop new forms of forward guidance well in advance of when existing thresholds are crossed. Central banks can also still learn from best practice as the “monetary policy glasnost” continues.

For example, the Fed has embraced press conferences, publishing the path for policy rates and the longer term economic projections of FOMC members, and has clarified its reaction function with the Statement of Longer-Run Goals and Policy Strategy (2012). The Bank of Japan’s communication strategy has been enhanced by the adoption of a clear 2 per cent inflation target. The ECB, meanwhile, is considering how it can publish more information on its policy debates.

With the current decoupling disconnect between economic cycles on either
side of the Atlantic, the ECB should
also consider other ways to strengthen forward guidance, including publication of an expanded horizon, with more component detail, of its staff economic projections.

There has been a torrent of new communication initiatives by central banks since the financial crisis. We can expect further enhancements in 2014.

Julian Callow is chief international economist at Barclays