Financial market volatility, and apparent recent missteps in central bank communications, are expected to be a central focus of discussion as countries gather for the 2013 IMF annual meetings in Washington.
The overriding communication challenge derives from central banks’ use of unconventional monetary policies — policy interest rates at the effective lower bound, the phenomenal expansion of central bank balance sheets and forward guidance (policy commitments conditional on future economic developments).
The balance of evidence supports the view that these unconventional measures have been positive for growth over the past five years, having had an impact through record low interest rates, portfolio rebalancing effects, wealth effects and signalling. Given the state of the global economy, all indications point to the likelihood that we will be living with unconventional monetary policies for some time to come.
US Federal Reserve Chairman Ben Bernanke, however, has raised the possibility of a slowing, or “tapering,” in the pace of Fed asset purchases. Since mentioning this possibility last May, financial markets have taken the view that this represents the “beginning of the end of easy money.” In response, there has been considerable volatility in interest rates with the 10-year Treasury yield backing up to a high of nearly three percent. Indeed, prior to the recent September 18 Federal Open Market Committee (FOMC) meeting, there was considerable speculation and positioning in markets that the Fed would announce the beginning of its tapering program. The FOMC instead opted to adhere to its previous pace of asset purchases, and appeared to modify somewhat its forward guidance. The 10-year Treasury yield immediately fell back 15 basis points to 2.70 percent.
What do we make of this? Specifically, what are the communication challenges with respect to exiting, or unwinding, unconventional monetary policies? Are there things that can be done to smooth this transition?
Managing Market Expectations
Financial markets are inherently forward looking. They embody the views of savers and investors regarding the future value of claims. Moreover, in today’s highly integrated financial markets, movements and expectations of movements in interest rates in one market impact financial prices across term to maturity, across securities and across currencies. Importantly as well, the forward-looking nature of these linkages means that financial asset prices are prone to adjust rapidly to developments and announcements.
Financial markets are also prone to overshoot (Dornbusch 1976). So a degree of financial market volatility should be expected, and indeed welcomed, as an indication that markets are re-pricing assets in response to new information and changing developments. The role of central bank communications is to add positively to the information flow, which helps to shape financial market expectations consistent with the thrust of policy.
In its communications around possible tapering of its asset purchases, and exiting from unconventional monetary policy more generally, the Fed has provided considerable information. For example, the withdrawal of stimulus would proceed with a gradual decrease in the size of the Fed’s purchases before it would begin to end purchases, and it would engineer a measured increase in the Fed’s funds rate. It provides an economic and inflation outlook, and risks to the outlook. And it has introduced forward guidance to provide a sense, though vaguely so, of the timing of its actions by linking those potential actions to the evolution of the economy.
Still, uncertainly prevails with regard to the Fed’s intentions. What seems to be missing is a sense of the Fed’s reaction function — the amount and timing of stimulus withdrawal needed in response to developments, or expected developments, in the economy. The Fed itself is unclear about this, given the unprecedented nature of monetary accommodation that has been provided, as well as uncertainty about the state of the economy.
Communicating Unconventional Monetary Policy
Notwithstanding this highly unusual situation, we need to ask what more the Fed, and indeed other central banks, can do through communications to provide further understanding of its thinking, thereby helping reduce market uncertainty and volatility. Three areas in particular should be considered:
Timely updates: In the absence of a more detailed outlook for the economy — a quarterly projection path, the amount of excess capacity and how quickly it will close, for example — the Fed should consider providing more timely updates of how the economy is unfolding relative to its expectations.
More focus on inflation: It is one thing for the Fed to indicate that inflation is below the FOMC’s “longer-run target.” It is another to indicate how underlying inflation dynamics could move inflation towards the long-run objective. In the absence of more analysis of inflation, inflation risk premium in medium-to-longer-term interest rates could be both high and volatile. Any concern about a fiscal risk premium only strengthens this consideration.
Attention to monetary conditions overall: While tapering and eventual sales of assets is being presented separately from any decision to begin raising the Fed funds rate, the two in fact are inextricably linked. The duration of holding the Fed funds rate at, or close to, its zero lower bound will be a function of the impact of tapering or sales on the yield curve weighed against the desired overall level of monetary conditions.
While there have been some encouraging signs, the global economic outlook remains highly uncertain.
Discussions at the upcoming IMF meetings will focus intently on the outlook, risks to the outlook and the right policy mix to promote broad-based, sustained growth. What can be done to improve central bank communications in support of global growth needs be part of that dialogue. The three considerations outlined above are intended to help encourage that dialogue and contribute to monetary policy being a source of certainty, not uncertainty, at a critical juncture in the recovery of the global economy from the global financial crisis.
Dornbusch, R. 1976. “Expectations and Exchange Rate Dynamics.” Journal of Political Economy 84 (6): 1161–76.