Central Bank News: More Cuts and Criticism of the Fed

Monetary Policy Week in Review – Sep 23-27, 2013: Israel, Hungary cut, Fed move sparks criticism of communication

by Peter Nielsen, Central Bank News

Last week the central banks of Israel and Hungary cut their policy rates while 10 other banks maintained rates as the U.S. Federal Reserve’s surprise decision to delay tapering its asset purchases reverberated through global markets amid criticism of its communication skills and forward guidance.

The Bank of Israel, which surprised financial markets by cutting its policy rate for the third time this year, cited the Fed’s decision as a sign of a possible slowdown in advanced economies while the National Bank of Hungary again trimmed its rate, taking advantage of a relief rally and rebound in emerging market currencies.

Although the Central Bank of Nigeria saw reduced risks of currency instability from the Fed’s decision, both it and Taiwan’s central bank acknowledged that an eventual reduction in asset purchases remains a major risk for the global economy.

In addition to Nigeria and Taiwan, the central banks of Armenia, Morocco, Georgia, the CzechRepublic, Trinidad & Tobago, Colombia, Rwanda and Malawi maintained their policy rates last week.

The Fed’s surprise decision to postpone tapering may have consequences for the future conduct of monetary policy.

Although the Fed’s policy-making body, the Federal Open Market Committee (FOMC), never said September would herald the start of winding down asset purchases, there had been enough winks and nods in that direction from governors and Fed bank presidents to convince financial markets.

The point of forward guidance as an additional communication tool is to help reduce investors’ uncertainty about the path of monetary policy, whether this guidance is open-ended, time-contingent or state-dependent, as in the case of the Fed.

While no one is arguing the merits of the Fed’s decision to postpone tapering due to lackluster employment growth or the impact of a potential U.S. government shutdown, serious questions are being raised about forward guidance if investors’ expectations turn out to be so wrong, as brutally witnessed on Sept. 18.

Ever since May, when Federal Reserve Chairman Ben Bernanke first raised the issue of tapering, global financial markets have been volatile as they adjust to a change in the flow of global capital, higher long-term interest rates, a depreciation of emerging market currencies and better economic prospects for advanced economies.

The process of exiting from extraordinary accommodative monetary policy was always going to be tricky and forward guidance was intended to help central banks keep long-term interest rates low as the economy heals from the scars from the financial crises.

But instead, long-term rates in most countries have shot up, threatening economic recovery and raising doubts over the efficacy of central bank’s communication via forward guidance, whether this was implemented by the Fed, the European Central Bank or the Bank of England.

By adding more predictability and transparency to central banks’ policy, forward guidance was supposed to reduce market volatility, not confuse investors and make them even more nervous as they scratch their heads, wondering how they could have misread the Fed.

So far, much of the criticism directed toward the Fed – even that by its own governors and presidents – has focused on its ability to communicate and not the basic concept of forward guidance.

But the consequence of the Fed’s deliberate policy of vagueness and uncertainty about winding down quantitative easing may have serious consequences, as witnessed by Richard Fisher, president of the Dallas Fed, who said last week’s decision called into question the credibility of the Fed’s communications.

Hopefully central banks and the Fed will learn from this error and look back at their notes from this year’s Jackson Hole conference where economists Arvind Krishnamurthy and Annette Vissing-Jorgensen called on the Fed to spell out the exact conditions for winding down quantitative easing to avoid a further damaging rise in long-term interest rates.  They wrote in their paper
“The Ins and Outs of LSAPs”:

“Since the prices of long maturity assets are much more sensitive to expectations about future policy than short maturity assets, controlling those expectations is of central importance in the transmission mechanism of QE. Therefore, how an exit is communicated to investors matter greatly.”

Net for the first 39 weeks of this year

The global trend toward lower policy rates appears to be bottoming out as emerging markets raise rates to limit the inflationary follow-through from currency depreciation.

Policy rates have been cut 88 times so far this year, or 23.3 percent of this year’s 377 policy decisions that by the 90 central banks followed by Central Bank News. This is down from 23.6 percent the previous week, 23.9 percent two weeks ago and 25.3 percent after the first half of 2013.

Meanwhile, the percentage of rate increases is slowly creeping up.

Central banks have raised rates 21 times, or 5.6 percent of this year’s policy decisions, down from 5.8 percent the previous week but unchanged from 5.6 percent two weeks ago and up from 4.7 percent at then end of June.

Emerging markets account for 43 percent of the 21 rate rises, with Brazil, Indonesia and India accounting for eight of those rate rises.

LAST WEEK’S (WEEK 39) MONETARY POLICY DECISIONS:

This week (week 40)

Eight central banks are scheduled to hold policy meetings, including those from Angola, Romania, Mauritius, Australia, Poland, Iceland, the euro area and Japan.