Events of the last week, including today at the ECB, should provide valuable lessons for the Federal Reserve as it formulates an exit strategy from its accommodative monetary policy. During the financial crisis, the Fed placed significant emphasis on providing forward guidance as a way to influence expectations so that market behavior would complement and more gracefully accommodate its series of quantitative easing programs and its low target range for the federal funds rate.
Lesson Learned?
In contrast, the Swiss National Bank abruptly, and without any hint, warning or guidance abandoned its policy of pegging the Swiss franc to the euro. The resulting market turmoil, the huge losses incurred by traders and even the failures of firms that had put positions in place in the belief that the peg was permanent should stand as a lesson to the Fed and other central banks contemplating policy changes.
The abrupt change in Swiss exchange-rate policy stands in sharp contrast to the measured approach that the People’s Bank of China has taken to relaxing its fixed exchange-rate policy. Its announcement of a gradual and reasonably predictable relaxation of the peg by specifying a band within which the currency is permitted to float did not disrupt markets; instead it permitted market participants to plan and manage their positions.
Central bank communications policy is challenging and not nearly as manageable as the academic models presume, because the models assume away what turn out to be critical elements of market participants’ behavior. Clearly, communication trumps surprise as a strategy.
Enabling The Front Runners
However, the process of communication should also be informed by what has happened as the ECB began contemplating the installation of its own program of quantitative easing. ECB officials began leaking details of policies to be considered in advance of its meeting, with conflicting messages concerning the likely duration of a program being widely reported in the financial media. Putting out specific options that differ in significant details caused uncertainty in advance of the ECB’s meeting. It likely encouraged front running by market participants in anticipation of the likely change in policy. Such mixed communications, too, are undesirable and are certainly not a useful way to conduct forward guidance. Markets are now adjusting to the meeting result and Draghi’s press conference.
So what do these developments mean for the Fed? They mean that the FOMC should first decide on its desired path for rates and then decide how to describe that path to markets. The FOMC set a precedent of offering generally clear communications when its previous policies were put in place, and it now faces the problem of how to communicate just as constructively as it engineers its exit from those policies. The dilemma is that the FOMC now seems to have embarked upon a partial approach to communications, as it has changed the wording in its statement from suggesting that rates may remain low for a “considerable period of time” to indicating that it can be “patient.”
More importantly, it has tried to uncouple the two phrases from any fixed time reference and has instead sought to convince markets that its policies will be data dependent. But, as we have argued in previous commentaries, the FOMC has failed so far to indicate precisely what data will condition policy and how, and thus it has essentially returned us to a world in which there is no meaningful forward guidance to help condition expectations. Unless it uses a more precise approach to forward guidance as a policy tool, the FOMC risks creating much uncertainty and market turmoil as it begins to change policy. These risks have only been highlighted by the recent experiences of other central banks.
Bob Eisenbeis, Vice Chairman & Chief Monetary Economist