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Satyajit Das: The years of talking dangerously

Theorists and central bankers are animated about forward guidance. But increasing reliance on the same is drawing unwanted focus on the limitation of central banking instruments and policy

Satyajit Das 

Satyajit Das

During the Second World War, everyone understood that loose lips sink ship. Over the last 18 months or so, central bankers and policy-makers have disregarded this advice, becoming excessively chatty. Research confirms the increase in length and complexity in the US Federal Reserve's statements, paralleling the rise in the size of its balance sheet.

Facing intractable problems and difficult choices, politicians have abnegated economic leadership to central bankers. With limited policy options available, central bankers have resorted to "forward guidance"; a tautology as any guidance must be about future events. They now communicate commitments on future interest rates, liquidity provision or QE and currency values over a medium- to long time horizon.

Forward guidance suffers from a number of weaknesses. Focus on any single or a narrowly based set of indicators, such as unemployment or inflation, is not meaningful. Forward guidance relies on the accuracy of central bank. Guidance is highly conditional. Central bankers have 'no skin in the game' with central bankers' tenure or remuneration is also not linked to outcomes.

An unanticipated trigger event can lead to a sudden and sharp automatic rule-based central banking response or policy change. In January 2015, the Swiss National Bank's sudden decision to abandon its currency peg highlights the problem. It created volatility and uncertainty, precisely the opposite of the policy intention.

Forward guidance increasingly confirms John Maynard Keynes's fear that: "confusion of thought and feeling leads to confusion of speech".

The US Fed committed to keeping rates low until the unemployment rate fell below 6 per cent. In early 2014, the Fed changed the unemployment target to a non-binding indicator. In May 2014, the full-employment goal was changed to cover the "disadvantaged", including long-term unemployed and workers forced to work part-time. The bank of Japan and the European Central Bank (ECB) targeted 2 per cent inflation, despite the fact that actual inflation was near zero and proving unresponsive to traditional policies.

In March 2014, at her first press conference, Fed Chairman Janet Yellen stated the Fed would not increase interest rates for a "considerable time". When questioned about Fed staff forecasts, which showed rates rising earlier than expected, Yellen hedged: "I would simply warn you that these dots (Fed Funds Forecasts) are going to move up and down over time a little bit this way or that... I really don't think it's appropriate to read very much into it." Not inconsiderable attempts at defining "considerable" proved unhelpful. In December 2014, the Fed announced they would be "patient", dropping the reference to "considerable time", driving new semantic speculation.

European central bankers lead the world in policy linguistics.

On July 4, 2013, ECB President Mario Draghi announced: "Key ECB rates [will] remain at present or lower levels for an extended period of time". On July 5, 2013, Governor of the Bank of Finland Erkki Liikanen stated that: "Everything depends on the development of the economy". On July 6, 2013, ECB board member Benoit Coeure observed: "[Forward guidance is] a change in communication but not in monetary policy strategy". On July 8, 2013, President Draghi provided clarification: "We'll have to see what the market reaction has been, is and will be to this statement". On July 9, 2013, ECB board member Joerg Asmussen gave specific guidance: "[The period] is not six months, it's not 12, it goes beyond". The ECB immediately issued a statement that Asmussen did not intend to give guidance on the exact length of time for which it expects to keep rates at record lows. On July 11, 2013, Bundesbank President Jens Weidmann resorted to classical allusion: "It is not an absolute advanced commitment of the interest rate path.

The ECB Council has not, like Odysseus, simply tied itself to the mast".

In January 2015, ECB President Draghi assured German newspaper Handelsblatt that "the risk [of deflation] cannot be entirely excluded" and "we have to act against such risk". Private transcripts of interviews with former US Treasury Secretary Timothy Geithner, which have inadvertently become public, confirm suspicions that Draghi has no actual plan, making it up as he goes along.

Theorists and central bankers are animated about forward guidance, with a torrent of papers and conferences on the subject. But increasing reliance on forward guidance is drawing unwanted focus on the limitation of central banking instruments and policy. With fiscal policy constrained and monetary policy stretched, the real problem is few available options, with central banks forced to experiment with techniques of unknown efficacy and potentially toxic side effects, including direct intervention in markets and pricing mechanisms.

As the Swiss franc episode reinforces, central bankers are not divine beings with supernatural powers. They are subject to market forces.

The current artificial economic environment is based on central bank manipulation of markets and prices and suppression of volatility. Despite the chatter and 'spin', it will not end well!



The writer is a former banker and author of Extreme Money and Traders, Guns & Money

First Published: Mon, January 26 2015. 21:49 IST
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