Adding to the central bank confusion this week, is this FT story by US economics editor Krishna Guha:
When the Federal Reserve cut interest rates to virtually zero in December last year, it told the market it expected to keep them there for quite a while.
The message was in a key line in the Fed statement that said “weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time”. The idea was to give additional stimulus by lowering market expectations of the future path of interest rates.
In March, the Fed went a step further and said the committee “anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period”.
Ever since, the US central bank has stuck with the “extended period” phrase – indicating policymakers see little likelihood that interest rates will rise over a time frame that has never been defined, but some see as at least six months.
But now senior officials are starting to mull changing the statement in a way that would soften this guidance. That would be a natural step in the slow glide- path towards eventual policy normalisation.
They key thing here is that the Fed wants to avoid a situation where it might have to abruptly moved from that “extended period” of very low rates, to an interest rate rise. As the FT story notes, however, changing the language even slightly could be misinterpreted by the markets as a sign that a rate rise is imminent when it’s actually not — the Fed just wants to signal that it’s aware of the inflation risk and will act as appropriate, eventually.
If all of this sounds confusing it’s because, well, it is.
As we’ve noted before, there’s a rather delicate (and probably untenable) balancing act that central banks are having to perform at the moment. A hefty portion of the market is pricing in interest rate rises in 2010, followed swiftly by inflation, at the same time that central banks are screaming to themselves about that “extended period” of low interest rates and deflationary risk.
Expectations themselves can have an impact on inflation and hence we see moves like the above — to manage those expectations — from the Fed. (Changing the language might also be a tacit admission that the output gap — a measure of how much ‘slack’ or spare capacity there is in an economy — is not working as the central bank expected.)
At the same time, the Bank of England has also been on expectation control-patrol this week. The BoE’s problem, however, is that they’ve simply been no good at getting their message across. We’ve had comments from the likes of Monetary Policy Committee member Adam Posen to the effect that the Bank is ready to increase its £175bn quantitative easing programme (October 18), followed swiftly by quotes such as: “In the medium term, meaning more than six months out, there’s no question that we’re going to have to reverse the extreme policy measures that we took” (October 23).
It’s probably simply the case that, like the Fed, the BoE doesn’t really know what’s ahead of it — rapid recovery and mild or extreme inflation, or a very slow crawl to economic growth with associated deflation or stagflation. Friday’s surprise UK GDP figures only serve to highlight this forecasting difficulty.
In the meantime though, given the market’s sensitivity to comments about quantitative easing, we’re not sure whiplashing expectations is necessarily the best way forward:
Related links:
The interest rate disconnect – FT Alphaville
If a central banker screams in a forest – FT Alphaville
My King-dom for some QE guidance – FT Alphaville