Thursday, December 12, 2019
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Central banks caught in a loop of promises

London: Key central banks appear to be down to their last tool: making promises. Unfortunately these promises — “forward guidance” in banker parlance — are ones they appear unable to honour for more than a few months, and ones that investors demonstrably didn’t believe while they lasted.

With interest rates close to zero, central bankers have limited levers with which to move the economy one way or another. Quantitative easing — buying bonds or other assets — is one option, but there are good reasons to believe that while it ratchets up values in financial markets, it does so at the risk of causing dislocations and with uncertain benefit to the actual economy.

That leaves forward guidance, in which central bankers try to guide expectations about when and why they will change policy. If it works it can allow central bankers to control longer-term interest rates despite an inability to cut them further. It is a bit like a free pass — no cost, easy to retract and theoretically quite useful.

Useful in theory, but extremely thorny in practice. To work, two key things have to happen; the central bank has to make good predications about the future and the market has to believe they will act as they’ve indicated they would.

Take the Federal Reserve, which has flagged unemployment falling to 6.5 per cent as part of its forward guidance about when it may consider raising rates. For reasons of demographics and a host of other issues, the US unemployment rate has fallen rapidly — now standing at 6.6 per cent — but the rest of the economy has not followed along.

That puts pressure on the Fed to revise its goalposts, and in itself, given the central bank’s desire to cut back on quantitative easing, undermines them even as they do. “The Fed is effectively out of bullets. ‘QE-Infinity’ was never possible in practice, though it sounded good in theory,” London-based hedge fund manager Stephen Jen of SLJ Partners wrote in a note to clients. “‘Forward guidance’, which is a psychological game, is the Fed’s last bullet.”

The Fed adjusted this guidance in December when it began the taper, and other Fed officials have recently suggested that it could be supplemented or replaced by a broader array of employment indicators, or by making reference to the Fed’s own economic projections. But making predictions, as the old joke goes, is hard, especially about the future.

Just last August the Bank Of England unveiled a rather complicated set of forward guidance signposts, including a seven per cent unemployment rate, which it said then wouldn’t be hit until late in 2015. As it happens, British unemployment is now 7.1 per cent just months later and, though the BoE has left rates on hold, pressure is on to come up with a framework which better fits the facts at hand, which is a UK economy recovering somewhat but far from needing outright monetary tightening.

The BoE’s solution may well turn out to be falling back on a range of forecasts, or potentially a range of forecasts on a wider range of indicators, but in any event the two central problems will remain.

It is extremely difficult to predict economic data, and it is even harder to predict one’s own position relative to that data. That is the problem with all long-term contracts, even ones with plenty of escape clauses. Both parties to the contract, in this case the central bank and the markets, understand that everyone is going to do whatever they think is in their own best interest once they see how things turn out.

Any other expectation is silly. This leaves central banks, and investors, in a somewhat delicate position. It is fine for policymakers to have a pretend tool, and for investors to pretend to believe it, so long as events play along.

The big issue won’t be if a recovery comes too quickly. In that case, central banks will tighten and everyone will forget about forward guidance.

The problem comes, instead, if things get worse. Given that central banks seem less willing to buy assets, it will be much harder to get investors to believe forward guidance if it is called upon to seriously loosen policy.

Talking has it limits, let us hope we don’t reach them.