January 14th, 2014
Monetary Policy Week in Review – Jan 6 -10, 2014: ECB sharpens guidance as BOE likely to tweak its guidance
by Peter Nielsen, Central Bank News
Last week's main event in global monetary policy was the European Central Bank's (ECB) sharpening of its commitment to maintain an accommodative monetary policy, illustrating the advantage of its so-called 'open-ended guidance' and the contrast to the Bank of England's (BOE) version of 'state-contingent' guidance.
The ECB on Thursday underlined its readiness to "take further decisive action" if the inflation outlook worsens or money market rates rise. It also added the words of "strongly emphasizes" and "firmly reiterate" to its guidance from July that it will maintain an accommodative stance for a long as necessary and that rates are expected to remain at their current, or lower levels, for an extended period of time.
For the ECB, it was relatively simple to adjust its forward guidance to financial markets and investors seemed to understand the ECB's message.
Major central banks are currently employing their own versions of forward guidance with the ECB's version a qualitative indication of the length of time that it believes its policy rates will remain at current levels. The ECB has been very deliberate in not defining what it means by "extended period," even going so far as to issue a statement last July that corrected statements by board member Joerg Asmussen who said the period goes beyond 12 months.
The advantage of this open-ended guidance is clearly the flexibility it gives the ECB in adjusting its message to new economic data.
However, the drawback is the lack of specific information that can affect expectations about short-term interest rates.
The pros and cons of the BOE version of forward guidance, known as 'state-contingent' guidance, was also a topic of much public debate last week. In August the BOE adopted this form of forward guidance, saying it would not raise its bank rate from its current level of 0.5 percent at least until the unemployment rate had fallen to "a threshold of 7%."
But UK unemployment rate has fallen much faster than the BOE had projected so financial markets are now wondering whether the BOE will raise rates sooner than expected.
When the BOE set out its unemployment threshold in August, the UK unemployment rate was 7.8 percent and the rate was first forecast to hit the threshold in late 2016, implying the bank rate would first be raised that year. But the economy has improved much faster than projected and the jobless rate already fell to 7.4 percent in October and is forecast by some economists to hit the 7.0 percent threshold in coming months, raising the possibility that the BOE could raise rates already this year.
This has ignited speculation that the BOE could lower its unemployment threshold to 6.5 percent as the governor, and other BOE officials and most economists, do not believe the UK economy is strong enough right now to handle higher rates.
The UK debate echoes the debate within and around the Federal Reserve for most of last year. Like the BOE, the Fed picked unemployment as its threshold for considering any rate rise, with the Fed setting its eye on a jobless rate of 6.5 percent, a lower number given its dual mandate. A discussion over the Fed's forward guidance was triggered by its statement May 2013 that it may to start to reduce its asset purchases "in the next few meetings." Financial markets interpreted a tapering of asset purchases as sign that the Fed was getting ready to raise rates. But this was not the Fed's intention and Fed officials spent the next months making sure the markets understood that it was still a long way away from considering rate rises. Fed policymakers then debated how to strengthen the guidance surrounding its fed funds rate to avoid another spike in market rates when the eventual decision to trim asset purchases was taken.
The result was that in December, when the Fed announced it would start trimming asset purchases, it adjusted the guidance by adding the phrase that rates would be held at its current level "well past the time" that the unemployment rate reaches the 6.5 percent threshold.
So how is the BOE likely to respond based on the Fed's experience? The first point is that the BOE in August and in its latest November inflation report described the 7.0 percent unemployment rate as a "threshold" and not a "trigger" for a rate rise. Reaching the threshold will therefore not automatically result in a rate rise but rather merely open the discussion.
The second point is that the BOE, like the Fed, has been engaged in asset purchases, so-called quantitative easing.
A few economists had expected the BOE to issue a comment on its guidance last week following its policy meeting, but most are looking for the BOE to use the publication of its inflation report on Feb. 12 as the right occasion to fine-tune its guidance.
Based on the Fed's experience, the BOE is likely to do two things. First, it will reiterate and possibly tweak the guidance surrounding the unemployment threshold, emphasizing and repeating that the threshold is a "way station" - as Governor Mark Carney said in August - at which the bank will reassess its appropriate stance.
Lowering the unemployment threshold, as some commentators have suggested, after only six months seems very unlikely as it would damage the BOE's credibility.
Second, the BOE is likely to draw a distinction between its asset purchases and the bank rate. As the Fed's experience showed, investors and markets are not always adept at distinguishing between less monetary accommodation, i.e. taking the foot slightly off the gas pedal, and an actual tightening of the policy stance.
The BOE has been undertaking quantitative easing since March 2009 and last boosted the volume of its asset purchases in July 2012 to the current total of 375 billion pounds. At this point, the BOE is maintaining the stock of assets purchases, meaning that it reinvest bonds that mature.
Describing the conditions for winding down asset purchases as a prelude to normalizing policy would be an obvious first step by the BOE to ensure that investors don't confuse fewer asset purchases with monetary tightening and also strengthen the BOE's forward guidance.
In addition to the ECB and the BOE, the central banks that maintained rates last week included Poland, South Korea, Indonesia and Peru. The only bank that cut rates was Romania.
Through the first two weeks of the year, 2 central banks have cut their rates, or 20 percent of this year's 10 policy decisions taken by the 90 central banks followed by Central Bank News. The other 80 percent of decisions have favored unchanged rates. This compares with the end of 2013 when 23.2 percent of last year's 505 policy decision resulted in rate cuts.
LIST OF LAST WEEK'S (WEEK 2) DECISIONS:
- Romania cuts rate 25 bps to 3.75%, 5th cut in a row
- Poland to hold rates at least until end-June, sees recovery
- Korea holds rate steady, sees recovery, higher inflation
- Indonesia holds rate, sees inflation in target 2014 and 2015
- BOE maintains rate, QE target, adds no further comments
- ECB says will take "decisive action" if needed
- Peru maintains the reference interest rate at 4.0% (Central Reserve Bank of Peru)
TABLE WITH LAST WEEK'S MONETARY POLICY DECISIONS:
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This week (Week 3) four central banks will be deciding on monetary policy, including Brazil, Serbia, Chile and Egypt.
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