In this fourth post on CIGI’s panel at CEA 2014, we turn to the presentation by CIGI Senior Fellow Pierre Siklos.
As discussed in previous posts, an inflation targeting central bank will typically align its policy rate with an ideal medium term forecast that sees the bank achieving its inflation control target over the medium term.
However, there is always a strong dose of uncertainty in any forecast. This inevitably creates challenges for a central bank’s so-called “reaction function,” or how it responds to changes in its forward looking assessment of macroeconomic conditions.
A central bank may wish to "pre-empt" potential deflationary or inflationary pressures, to remove the need of more drastic actions at a later date. However, there is also the risk that a central bank may become too “trigger happy” and adjust its policy rate in response to threats to macroeconomic stability that never materialize.
As Siklos explained, this traditional tension between “pre-emption” and “patience” has only grown in the aftermath of the financial crisis, along with the potential risks of getting the balance wrong.
Facing stubborn output gaps — and often dysfunctional fiscal policy — central bankers in many advanced countries have been inclined to exercise a strong degree of patience in waiting for their economies to heal from the long-term wounds inflicted by the global financial crisis. For example, despite strong improvements in headline unemployment figures in both England and the US, both central banks see far more economic slack than these figures suggest.
In the UK, productivity growth has been abysmal; while in the US labour force participation rates remain significantly below pre-crisis levels. Both these dynamics suggest ample room for further non-inflationary growth.
To convince markets of their willingness to keep monetary policy accommodative even once growth (finally) accelerates back to trend, central banks have experimented with a range of communication strategies – whose success ultimately hinges on credibility and clarity.
While most central banks in western countries see limited risk in overshooting their inflation targets (indeed in the euro area persistent undershooting remains the major risk); many are less certain about threats to financial stability arising from continued zero-rate policies.
Here a strong case can be made for “pre-emption.” Voting members of numerous central banks (along with the influential Bank for International Settlements) have publically signalled their concern over the potential of growing financial imbalances.
In theory, central banks now have an arsenal of new macroprudential tools to directly target these sources of financial instability. However, essentially all of these levers of economic management are of questionable efficacy — while many have simply never even been tested.
The great thing about using the traditional policy rate to affect financial conditions is that it gets “in all the cracks.”
The problem, of course, is that expressing concern over the potential for sustained outputs gaps to permanently scare an economy, on the one hand, and of financial instability stemming from easy money policy on the other, leads to muddled central bank communication.
As Siklos noted, market participants appear to believe that ultimately most central banks will opt for continued patience. However, when eventual rate hike decisions do come, there is a risk of markets “over-reacting.” Unprecedentedly large central bank balance sheets will similarly only complicate the exit from the zero lower bound.
Central banks have tried their best to communicate under what economic conditions rates will eventually rise — sometimes setting explicit numerical thresholds and commitments. The problem arises that heavy reliance on communication strategies, presumes that one can “treat the market as if it were an individual that you can sit down and reason with[1].”
Some high-profile central bankers have admitted as much publicly. For example, citing former Federal Reserve governor Jeremy Stein, Siklos stressed that the suggestion that "good communication alone can engineer a completely smooth exit from a period of extraordinary policy accommodation — is to create an unrealistic expectation.” Last year’s “taper tantrum” is a great example of the fallacy in this presumption.
Indeed, as Siklos argued in his concluding remarks, there has been a temptation in the new found use of communication strategies, to presume that monetary policy committees “can negotiate every contingency over time.” That fact is that this is simply impossible.
The longer we remain at the zero lower bound, the more we will have to be concerned over the negative spillovers of unconventional monetary policies. In the process, the tension between patience and pre-emption will only grow.
Welcome to the brave new world of monetary policy. Hold on for the bumpy ride.
[1] This quote is from Hyun Song Shin’s 2013 Jackson Hole address, titled “The routes into and out of the Zero Lower Bound”.