Lucy O'Carroll, chief economist at SWIP, takes a look at the challenges faced by central banks in light of a steady global recovery.
Forward guidance is all the rage among central banks. The Bank of England (BoE) and European Central Bank (ECB) have joined the US Federal Reserve in an attempt to influence expectations about the future pace of stimulus withdrawal.
All three are essentially trying to do two things. Firstly, they are aiming to convince markets that policy will remain loose for some time.
Secondly, they are trying to reduce the risk of a sharp correction in bond markets, which may be uncertain about the timing and impact of this new policy phase.
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For the BoE, this marks a significant change in the way policy is communicated. In the Monetary Policy Committee’s (MPC) view, forward guidance will improve monetary policy effectiveness by giving greater clarity on the balance it has to strike between getting inflation back to target (requiring rate rises) and ensuring a recovery in growth and employment (requiring monetary stimulus).
It should also reduce the risk that, as activity picks up, markets will be too quick to price in rate rises, so derailing recovery.
Finally, through the adoption of ‘knockouts’ – allowing the MPC to tighten policy quicker than indicated by its 7% unemployment threshold if it believes either its inflation-fighting credibility or financial stability are at risk – the committee says it has created a “robust framework” for keeping rates low for longer.
The MPC argues the unemployment rate is “the most suitable indicator of economic activity” for its threshold, since it relates directly to the amount of spare capacity in the economy.
Ultimately, it is this degree of economic slack that determines the rate of inflation – the committee’s primary target. The unemployment rate is also not prone to substantial revisions (in contrast to GDP, for example) and is – in the MPC’s view, at least – widely understood.
However, markets have reacted with scepticism: bond yields have risen sharply recently despite central bank messages that policy rates will remain low for longer.
The ECB has called the latest trend “unwarranted”, while the Reserve Bank of Australia has even cut rates to a new low. However, the central banker with most persuading to do is Ben Bernanke.
Despite his assurances the Fed will not do anything that could de-rail the recovery, investors seem more focused on their next monetary fix. For those willing to look beyond the effects of tapering, however, there is plenty of positive news.
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