Volatility Returns as Forward Guidance is Questioned

Monetary Policy Week in Review: 06-10 October 2014

by Peter Nielsen, Central Bank News

Volatility returned with a vengeance in financial markets last week as investors took fright of the prospect of slowing economic growth, especially in Europe, at the same time the U.S. Federal Reserve wraps up its asset purchases and gears up for its first rate rise in more than eight years.

Just how the Federal Reserve will communicate its future policy stance once the era of quantitative easing (QE) ends was one of the main topics discussed by the Federal Open Market Committee (FOMC) at their September meeting, according to the minutes released last week.

For almost two years, the FOMC has been applying the forward guidance that the fed funds rate would be maintained for “a considerable time” after QE ends.

It is now faced with the challenge of replacing that phrase with words that “avoid sending unintended signals about the Committee’s policy outlook,” as the minutes said.

At its meeting on Sept. 16 and 17, the FOMC confirmed that it would end its asset purchase program at its meeting Oct. 29 with the final purchases in November, if the labor market continues to improve and inflation moves toward its 2.0 percent goal.

Whether that timetable remains intact has now been thrown into doubt by the slowdown in global growth and the rising dollar that could hold back inflation, according to several FOMC members in recent days. How central banks can communicate their intended policy amid a sea uncertainty was the focus of a speech last week by Bank of Canada Governor (BOC) Stephen Poloz, who noted “there may be significant volatility when markets perceive the central bank is preparing to change its position.”

Poloz describes the recent use of forward guidance as taking certain policy options off the table, a move that is tantamount to giving the market a one-way bet.

With memories of last summer’s “taper tantrum” still fresh in most investors’ memories, Poloz says financial markets respond to such one-way bets with leveraged positions so its hardly a surprise that volatility returns when it looks like the guidance is being changed.

Another potential downside of forward guidance is that it is conditional upon economic forecasts. These assumptions become caveats for the guidance so fragile markets end up needing repeated assurances in light of new data that may undermine the forecasts.

Poloz said:

“In short, forward guidance can become addictive for markets if it is overly precise or heavily weighted with caveats”.

Poloz’ conclusion is that forward guidance is useful but should be reserved primarily at the zero lower bound. During more normal times, central banks should offer full transparency of the risks the are weighing in policy deliberations.

This allows financial markets to assess new information in sync with the central bank so the market remains two-way and less vulnerable to unusual leveraging and volatile shifts in sentiment.

Poloz said:

“Essentially, the net effect of dropping forward guidance is to shift some of the policy uncertainty from the central bank’s plate back onto the market’s plate, a more desirable situation in normal times” .

Through the first 41 weeks of this year, the 90 central banks followed by Central Bank News have cut their policy rates 51 times, or 13.5 percent of all policy decisions, up from 12 percent at the end of the first half and 12 percent at the end of the first quarter.

Central banks in advanced economies have accounted for six of the rate reductions, with Israel cutting its rate three times, the European Central Bank twice and Sweden once. Meanwhile, rates have been raised 38 times, or 10 percent of all policy decisions, up from 9.3 percent at the end of June and 8.7 percent at the end of March.

Among advanced economies, only New Zealand has raised its rate four times while emerging market central banks have raised rates 18 times, frontier market central banks three times and other central banks 12 times. LIST OF LAST WEEK’S CENTRAL BANK DECISIONS:

• Australia holds rate steady, still see period of stable rates
• BOJ maintains policy stance, sees production weakness
• Indonesia maintains rates as inflation still on target
• Poland slashes rate 50 bps, may cut more if inflation falls
• BOE maintains rate, stock of assets, as expected
• Tajikistan raises rate 100 bps on inflationary pressures
• Peru maintains rate, but will ease if necessary

TABLE WITH LAST WEEK’S MONETARY POLICY DECISIONS:

This week (Week 42) seven central banks or monetary authorities are scheduled to decide on monetary policy: Uganda, Singapore, South Korea, Serbia, Egypt, Chile and Sri Lanka. TABLE WITH THIS WEEK’S MONETARY POLICY DECISIONS:

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