Fed and BOE have lost their way on forward guidance and are flying blind

The US and British central banks have been sending out mixed messages on interest rates, undermining the performance of markets

PUBLISHED : Sunday, 08 November, 2015, 11:16pm
UPDATED : Sunday, 08 November, 2015, 11:17pm

In recent years, major central banks such as the United States Federal Reserve and the Bank of England have relied on forward guidance as their main tool for getting the message across to markets on where they see - and want - future interest rate levels.

By guiding rational expectations on future rate moves, it is supposed to spare markets needless worry over volatile rate movements. Uncertainty on interest rates can be bad news for exchange rate stability, financial market performance and economic well-being.

Forward guidance is supposed to build confidence, not wreck it. But in recent months, the Fed and the BOE seem to have lost their bearings and have struggled to emerge from the monetary maze of zero rates and unprecedented balance sheet explosion following quantitative easing programmes with any meaningful sense of direction.

Gut instincts have long been begging both banks to begin the long road back to monetary normality. But they have been bogged down by conflicting data, global stability concerns and, at times, deep-rooted indecision. The mixed messages picked up by the markets have made matters worse.

Both banks have failed to grasp the nettle with clearer determination one way or the other. It has left a policy vacuum and made it tougher for consumers, businesses and markets to make credible spending and investment decisions.

Back in the summer, the BOE hinted that higher rates were on the way by the turn of the year, while the Fed had been leading the markets to believe that a September rate rise had been on the cards. Now, the BOE seems to be shying away from an early 2016 rate rise, while the Fed is leaning more to a rise next month.

If the Fed and BOE seem ambivalent, it is no surprise markets are in a muddle. For years they have nailed their colours to the mast of stronger recovery, higher inflation and more settled global factors. Sadly, it has not panned out that way.

While the US and British economies have fared better than most, they are both experiencing patchwork recoveries. Deflation risks still abound and there seems little chance of them hitting inflation targets within a reasonable timeframe. Growing uncertainties in emerging economies are also throwing a major spanner into the works for their rate-tightening plans.

At some point the economic data will eventually begin to make a difference and they will be forced to raise rates. That point is approaching the US before Britain.

With the Fed so besotted with the notion of getting rates off their "unnatural" zero floor, it is bound to take a cue from last month's robust employment data. With jobs growth surging and unemployment hitting a 71/2-year low, the Fed now has its excuse for a December rate rise.

But it will have nobody to blame but itself when debt-laden and rate-sensitive emerging markets begin to tremble again and when the resurgent US dollar takes a greater toll on US exporters' trade competitiveness.

It could face the consequences of a damaging and embarrassing policy U-turn. Except cutting rates from close to zero will make no difference. The Fed might need to reopen its doors to more quantitative easing to stop the global economy from hurtling headlong into deep crisis again.

In contrast, the BOE seems to be taking a much more sanguine look at inflation and defusing rate-tightening expectations until the second half of next year. This is a sour note for consumers and businesses that have already remortgaged and refinanced on the back of previously hawkish hints, ending up with costlier debt charges in the process.

The markets are being forced to change their tune as well. Just recently, rising rate bets had left currency traders extremely bullish on the pound, but these are now beating a retreat. Dollar bulls are back in the driving seat.

It is time for the Fed and the BOE to straighten the picture and be much more candid with the markets about their true intentions. Plain speaking by central banks is vital for future credibility, better market trust and stronger economic confidence.

The last thing the markets need is smoke and mirrors.