Why it matters to persuade global markets
- 14 August 2013
- From the section Business
The eurozone has exited the longest recession on record and there are signs of economic recovery from the US to the UK to Japan.
These are positive developments, but could add to confusion too, as more will wonder when interest rates will rise if growth picks up. Guiding expectations is more important than ever.
Indeed, from the Federal Reserve to the Bank of England and the European Central Bank, there is a move to guide markets more explicitly than before. But, why aren't global markets - those who the central bankers aim to guide - persuaded?
First, a reminder as to why it matters. When a central bank sets the interest rate, commercial lenders then decide how much to charge for loans to you and me.
Our cost will usually be a bit higher so they make a profit. The cost of borrowing for consumers and businesses depends on what the banks and bond markets think the rate will be in the future and thus what they will charge to lend.
Now, on to why markets are sceptical. And, this is where I should provide a word of warning as this could be wonkish.
When the Fed sets out to target explicitly the other part of its dual mandate, manage unemployment as well as inflation, it is part of a policy to increase transparency.
When the Fed for the first time targeted 6.5% unemployment as a goal, it also set out each rate setter's own forecast as to when he or she expects rates will rise.
The Fed had only set an explicit inflation target of 2% shortly before that, so setting out a specific number instead of just aiming for price stability was part of the overall changes to the policy framework.
Recently, European central banks have followed suit, but only in terms of the pledge to keep rates low "for an extended period" and in the Bank of England's case, until unemployment hits 7%.
I'll come back to this, as raising transparency may not work if you stop at one element which is this so-called "forward guidance"' just on rates.
In all cases, it is subject to caveats. So, rates will stay low insofar as inflation doesn't exceed their 2% targets by too much, say it remains below 2.5%.
So, why aren't the markets buying it?
In fact, in the UK's case, sterling strengthened and shares fell, the precise opposite reaction to what would be expected if the forward guidance were persuasive.
Investors are acting not as if rates will stay low for, say, three years, but rather that they may go up sooner than that.
Okay, this is where it gets a bit wonky.
There's something called the Lucas critique, named after the Economics Nobel Laureate Robert Lucas.
Its premise is that the policymaking process itself alters the targeted variables.
It means that if a policy was designed based on how variables like inflation and unemployment related to each other in the past, it won't necessarily now.
To put it more bluntly, Goodhart's Law says that a variable that is used as a policy target quickly loses its reliability as an objective indicator. Think of all those who question the credibility of the 2% inflation targets.
To take an example. if globalisation alters the relationship between inflation and unemployment, so inflation is driven by global prices that don't have much to do with the domestic economy, then setting a policy that targets both based on past behaviour may not work too well.
For the truly wonkish, the short-run version of the Phillips curve that maps an inverse relationship between inflation and unemployment has flattened during the past few years.
It's similar for the unemployment rate and the level of output in the economy. In other words, if unemployment hasn't risen as much as the loss in output suggests it should have, then designing a policy targeting unemployment may not be effective.
Now, coming to why investors aren't entirely convinced. Take the UK, where inflation has been too high and unemployment rather low given the depth of the recession.
So, targeting unemployment may add more uncertainty around economic forecasts that are usually pretty uncertainty in any case.
For European central banks, more transparency would probably be useful to help markets anticipate where rates are headed.
Following the Fed's lead all the way, including making clear when each central banker expects rates to rise, may help with increasing clarity.
Since the rates that matter for our mortgages and business loans are set by commercial lenders and the bond markets, it certainly matters if central banks communicate effectively. So far, it looks like the jury is still out.