Global: More Tales of Three Central Banks
Joachim Fels (London)
Of old, young and Fed ladies
Contrasting and comparing various central banks’ approaches and policy stances can yield insights over and above those gained from focusing on each of them in isolation. I find it particularly instructive to compare the holy trinity consisting of the Fed, the ECB and the Bank of England. The first manages the world’s reserve currency, the second is the new kid on the block, and the latter is the ‘Old Lady’, who has a history going back to (yes) 1694 but also has perhaps the most modern policy and communication strategy of the three. Some of you may remember my piece A Tale of Three Central Banks of 21 July 2003, in which I pointed out a puzzling inverse relationship between the three banks’ transparency and predictability. The most predictable of the three in terms of interest rate changes (the Fed) was the least transparent, while the most transparent bank (the 'Old Lady') was the least predictable.
More predictability here, more transparency there
As I heard through the grapevine, the ‘Old Lady’ took this finding quite seriously, despite the fact that Mervyn King pooh-poohed my study in his inaugural press conference as Governor in August 2003. In any case, the Bank’s interest rate moves (five hikes since then) became almost perfectly predictable, with well-timed speeches and carefully crafted minutes providing good guidance. At the same time, the Fed has made progress on improving transparency, as highlighted by the FOMC’s decision in December to release its meeting minutes on an accelerated schedule as of this year. The first release on the new schedule -- three weeks after the FOMC meeting rather than only after the following meeting -- occurred earlier this week and has already received much attention by markets and commentators (see also Steve Roach’s Game Over? 7 January 2005, on this Forum). Here is my own take on the transparency and the broader monetary policy issues facing the Fed in the light of the minutes, as viewed against the backdrop of the ECB’s and the Bank of England’s respective approaches and stances.
When the Fed lady sings
As I see it, there are three main themes that emerge from the Fed minutes and from a comparison with the other two central Bank’s commentary and approaches. First, despite the accelerated minutes release schedule, the Fed still lags way behind the Bank and the ECB, especially in terms of goal transparency. Do you know what exactly the Fed is targeting? (Some say the Fed funds rate, but that's beside the point). Second, as the Fed keeps us all guessing about its precise goals, here is my own guess: the majority of FOMC members want inflation to creep higher from current levels and will thus be less aggressive in hiking rates than markets are pricing in, notwithstanding the hawkish tone of the minutes. Third, more policy divergence between the three central banks lies ahead this year, which should have interesting implications for bond markets. Let me elaborate.
More transparent now, but still hazy
If you have ever watched Big Brother, you may agree that more transparency is not always a good thing -- some things I just don’t want to know. But when it comes to watching central banks, most people would agree that more transparency is a good thing. Undoubtedly, the Fed’s move to publish the FOMC minutes before the following meeting enhances transparency as it gives markets a more up-to-date snapshot of policymakers’ views on the economy and markets. So far, markets had to infer the evolving views at the Fed from the short post-meeting statement, from individual policymakers’ speeches and from certain newspaper and newswire articles quoting “Fed sources”. The complete account of the meeting discussions was released only after the following FOMC meeting. As I showed in my July 2003 article, however, this way of drip-feeding information still enabled markets to get the Fed’s next interest move right almost 100% of the time since 1999. So, predictability has never been the Fed’s problem in recent years. Having said that, it is clearly preferable to get the official account of the internal discussions in the form of the FOMC minutes as soon as possible, rather than having to rely on second-hand accounts in the run-up to the next meeting.
Beauty and the beasts
Note, however, that despite this move, the Fed is still lagging the ECB and the Bank of England in terms of transparency on three important counts. First, both European institutions still inform the markets earlier of their discussions than the Fed, which now releases its minutes three weeks after the FOMC meeting. The ECB publishes a detailed statement intended to summarize the Council’s views and holds a press conference with a (lengthy) Q&A session on the very day of the meeting. The Bank of England releases the detailed MPC minutes and votes 13 days after its meeting. Second, the ECB publishes a (lengthy) Monthly Bulletin with a detailed analysis of all the economic and market factors influencing its decisions two weeks after the Council meeting; and the Bank publishes a detailed quarterly Inflation Report followed by a press conference and Q & A. Nothing comparable is published by the Fed. Third, and I think most importantly, the Fed is highly intransparent when it comes to its precise goals. Yes, it’s mandate is to preserve price stability and to care about sustainable growth and high employment. But what inflation rate does the Fed target, and which measure of inflation, and how does it trade off (if at all) between the growth, employment and inflation objectives? Like beauty, the answer is largely in the eye of the beholder. By contrast, the ECB has a clearly defined objective (price stability, defined as an increase of HICP inflation of below but close to two percent) and the Bank of England has a precisely defined target (2% CPI inflation), even though taming these beasts isn’t always easy. Against this backdrop, it is hardly surprising that long-term inflation expectations in the US are more volatile than in the euro area or in the UK. We don’t know what they aim at in Washington!
My guess: the Fed wants higher inflation
Clearly, the lack of transparency about the Fed’s inflation objective is a standing invitation to speculate about it. I beg our US economists, who are genuine experts on the Fed, to forgive me in advance. But my own guess is that, for most FOMC members, the current 1.5% or so increase in the core PCE deflator is simply too low for comfort over the medium term. Once the next negative shock hits, the rate of price increases would quickly fall back towards the deflation danger zone of below 1%, which it touched briefly in late 2003. By contrast, a gradual rise in inflation would keep the highly leveraged US economy afloat -- the more debt you have, the more you love inflation. How high the Fed wants to see inflation drifting, I don’t know. It probably depends on the economic circumstances. But I guess that the Fed implicitly has a significantly higher inflation goal than the ECB or the Bank of England. And if so, the Fed will probably lag market expectations in raising rates this year to ensure that inflation keeps creeping higher. I realize that this appears to stand in sharp contrast with the tone of the FOMC minutes, which were widely seen as hawkish. My reading, however, is that while “a number of participants” worried about upside risks to inflation and “some” worried about low rates fuelling asset price inflation, this was by no means a majority view among the voting members. Bottom line: US rates are headed higher in the next few meetings, but I think eventually rates won’t rise as much this year as the market is now pricing in (for a different view, see Steve Roach’s piece quoted above).
The three ladies don’t sing from the same sheet
My third theme is that the monetary policy paths in the US, in the euro area and in the UK are likely to diverge more this year than they did over the past few years. Just look at the rhetoric in the three banks’ December policy statements and minutes. According to the FOMC minutes, some members (though a minority) have expressed worries about upside risks to inflation and about asset price inflation. At the same time, the ECB moved from “strong” vigilance regarding inflation risks in November to “continued” vigilance in December and even dropped the phrase expressing concerns about asset price inflation. Meanwhile the December MPC minutes showed that some members were starting to worry about downside risks to the (benign) inflation outlook, which suggests to me that the odds of a rate cut this year have risen. The reasons for this emerging divergence are not difficult to find: currency appreciation reduces inflationary pressures in the euro area, and the developing downturn in the UK housing market could weigh down on UK consumer spending and inflation. With the Fed likely to raise rates at the next several meetings and inflation creeping higher, the ECB likely on hold at least until the middle of the year, and the Bank of England possibly starting to cut rates this year, my guess is that UK gilts will outperform both Bunds and US Treasuries. And, even though the trade has worked well for some time now and appears to be a high-consensus trade, Bunds have some more room to outperform US Treasuries, I think. It ain’t over until the Fed lady stops singing… |
