Markets Insight
July 16, 2013 2:45 pm
Central banks err in over-sharing
Central banks err in over-sharing
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.
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?
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.
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
Copyright The Financial Times Limited 2013.
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