Central banks losing their credibility over forward guidance

Leading central banks are losing their credibility with markets over forward guidance on monetary policies

PUBLISHED : Wednesday, 29 January, 2014, 5:02am
UPDATED : Wednesday, 29 January, 2014, 5:02am

Former United States president Ronald Reagan was known as the "great communicator" because of his uncanny ability to present voters with a simple, consistent and credible message.

At a time when international investors are hanging on every word uttered by the world's major central banks, the monetary guardians of Britain, the US and the euro zone are struggling to communicate their policies effectively, unsettling financial markets.

Central banks' communication tools are desperately in need of a Reaganesque overhaul.

Last week, Bank of England governor Mark Carney told the World Economic Forum in Davos that his policy of tying interest rates to the unemployment rate would be jettisoned, a mere six months after it was announced with great fanfare.

The US Federal Reserve, whose unemployment rate threshold - above which it will not increase interest rates - has more or less been reached, may be forced to follow suit.

As for the European Central Bank, although it has avoided the pitfalls associated with linking future interest rate decisions to a specific economic indicator, its monetary policy is being severely challenged by its reluctance to provide extra stimulus despite the threat of deflation and a premature rise in market interest rates.

For these leading central banks, the conduct of monetary policy known as "forward guidance", which is meant to give an element of predictability to interest rates, has been a case of "forward misguidance".

The BOE's pledge to keep interest rates at ultra-low levels has become the least credible.

Britain's economic recovery is the most pronounced among the world's major developed economies, driven by consumer spending and a buoyant housing market in London and southeast England. This is helping to lower the country's unemployment rate, which is now at 7.1 per cent, a whisker above the 7 per cent threshold rate which could trigger rate increases and a level which, as recently as in August last year, the BOE's own forecasters did not expect to be met until 2016.

Carney is now preparing the ground for a revised regime of forward guidance which would focus on a broader set of economic variables, presumably helping the central bank justify maintaining a highly accommodative policy stance for a considerable period.

The problem, however, is that Carney himself set great store by the unemployment rate as a gauge of the amount of slack in the economy. If the recent trend in unemployment continues, the pressure for a rise in interest rates before the end of this year will increase significantly. Indeed, Carney is already placing greater emphasis on the gradual nature of policy tightening once the first rate rise is undertaken.

All this is fertile ground for markets to test the BOE's resolve to keep rates at low levels. The whiff of a rate increase in Britain is in the air.

Meanwhile, the Fed, which is widely expected to announce a further scaling back, or "tapering", of its asset purchases at its monthly meeting this week, faces a similar challenge.

Janet Yellen, the incoming Fed chair, must decide whether to toughen up the Fed's own regime of forward guidance, which is currently based on a vague pledge to keep interest rates low "well past the time that the unemployment rate declines below 6.5 per cent".

Although unemployment in the US already stands at 6.7 per cent, this is mostly because of a fall in the participation rate. Yet this could also mean that there is less slack in the economy, strengthening the case for an earlier-than-expected increase in interest rates.

Markets are now buying into the Fed's message that "tapering isn't tightening". But the yield on two-year US treasuries, the gauge of bond markets' perception of interest rate movements, has been fluctuating of late, suggesting investors are in two minds about the odds of a rate increase in the next 12 months or so.

If the Fed loses control of the short end of the US yield curve, the fallout in emerging markets - which are already suffering a sharp sell-off - will become even more severe.

As for the ECB, which is under the most pressure to keep market interest rates at very low levels given the weakness of Europe's economy, verbal intervention is no longer sufficient.

Mario Draghi, the president of the ECB who turned investor sentiment towards the euro zone around with a pledge to do "whatever it takes" to keep the bloc intact, is struggling to undertake meaningful measures to ward off the threat of deflation and help nurture the zone's fledgling recovery.

Unlike the Fed, whose mandate extends to seeking "full employment", the ECB is focused solely on maintaining price stability, making it doubly difficult to provide dovish guidance.

The only question now is which of the three central banks will be tested by the markets the most in the coming weeks and months.

Nicholas Spiro is the managing director of Spiro Sovereign Strategy