Yes, rates will rise. Do control yourselves

Yes, rates will rise. Do control yourselves

David Keohane Author alerts

| May 23 09:45 | 4 comments | Share

From a tame taper to a rate rage? And on its birthday too.

As Alan Beattie says, it was a year ago this week that the “taper tantrum” shook emerging markets, after comments from Ben Bernanke raised fears of the Fed tightening monetary policy. That sucked for EMs even if the reaction to the actual taper, which began in December, was much more chilled.

But it’s what happens when rates eventually rise that’s perhaps more interesting now. From Lombard Street’s Dario Perkins (our emphasis):

Volatility should rise because policymakers will find it harder to signal their intentions once they start raising rates. At the zero bound, when the economy needed extra stimulus, it was easy for central bankers to commit to steady rates far into the future. They could even provide neat, numerical unemployment ‘thresholds’ to guide expectations. But now, partly because their previous guidance proved misleading and partly because interest-rate decisions are becoming more difficult, we are unlikely to revisit such extreme levels of transparency.Both the Fed and BoE have already ditched threshold-based policy, while the ECB is only partially revealing its QE ‘reaction function’. Over all, the central banks are trying to take back some policy discretion.

The best we can do is to summarise central-bank guidance in ‘dashboard’ form, based on those indicators we think they will be watching most closely. While this should provide a rough guide to how their thinking evolves over the next 12 months, it also leaves several important areas of uncertainty. To start, investors must remember that monetary policy is set by committees. When interest rates start to rise, different members on those committees could take different views about the timing/amount of tightening needed. This is already clear from the FOMC’s ‘dots’ chart, which shows broad policy disagreements from 2015. Compounding this, some critical economic trends are proving particularly hard to forecast, notably US participation and UK productivity. These will also have a crucial bearing on the pace of policy tightening.

With central banks less able to provide clear guidance about the future, we are likely to see renewed market volatility as they start to raise interest rates in 2015. Some investors will again be anxious to sell their bonds, fearing significantly higher yields. But as with the taper tantrum, we are unlikely to see a sustained 1994-style crash. Central banks will try to downplay the total amount of tightening that is coming, while favourable global developments – notably sustained low inflation and excess savings – should help keep yields pinned down at relatively low levels.

Basically, as central banks start to leave the zero bound, it’s going to be increasingly hard for them to provide concrete guidance. So they won’t. They have no intention of going back to the kind of transparency they were doling out in 2013 — where once you had numerical thresholds now you have a plethora of indicators and no specific targets. And that’s without even mentioning the ECB, its three contingencies and its jedi-in-chief.

From Perkins again:

Even if central bank policy was decided by a single unitary actor, that individual would find it more difficult to commit to certain actions as policy moved away from the zero bound. This was a point soon-to-be-departing FOMC member Jeremy Stein made in a recent speech. He argued that previous Fed guidance, notably their forecast that interest rates would not rise until unemployment fell below 6½% was a ‘relatively firm commitment’ from the FOMC. But the signals they have been providing about policy beyond that point are merely forecasts. He notes: ‘

When I fill in my ‘dot’ for the [FOMC’s economic projections] I think of myself as writing down not a commitment for where the federal funds rate will be at that time, but only my best forecast, and one that is highly uncertain’.

Stein argues that as policy normalizes, forward guidance will become less commitment-like and so a less precise guide to future policy actions. When interest rates are stuck at the zero bound in an economy that needs extra stimulus, it is easy to agree to a commitment to keep rates low. But as the economy returns to normal, differences in opinion will start to matter more. And because the central bank’s future intentions will not be fully fleshed out, they will struggle to precisely communicate them…

The implication of all this is that the outlook for monetary policy will become less predictable as central banks start to normalize policy. Risk premiums in markets should rise and we could again see another ‘tantrum’ in bonds. With yields still low by historical standards, some investors will be anxious to sell their bonds, especially if they think the initial rate increase marks the first of many. EMs could also come under renewed pressure. And, as the 2013 experience showed, this could happen even if policymakers merely move in line with current market expectations.

The bet is the global saving glut will eventually dampen down bond yields, as it did during the taper tantrum, but at least it might be interesting for a bit.