Central banking is changing rapidly

Seals of US Fed and B of E

Seals of the Fed & Bank of England

Central banking is changing fast: new monetary-policy tools are being tested, but they are also testing the sanity of traders! Several countries, including the USA, Britain and Japan, are finding that their new tools are not working as well as anticipated.

Before the financial crisis, central bankers were merely “one-trick ponies” who tinkered with short-term interest rates moving them up or down in quarter-point increments. Their aim was, and essentially remains, to influence growth and inflation rates. Unfortunately, following the financial crisis, even adjusting interest rates down to almost zero did not stimulate growth in weak economies. In what looks like a desperate measure, rather than any great new theory of economics, the central banks are now trying to use two new tools. The first is buying assets such as long-term bonds to push down long-term interest rates. The second is issuing so-called “forward guidance” to manage market sentiment. Forward guidance is effectively a promise to keep short-term interest rates “low” until targets, such as a particular unemployment rate is delivered.

However, sentiment simply cannot be changed by the blunt instrument of short-term interest rates; many other factors influence what people perceive and expect. Neither can asset purchases be a deftly wielded tool of change. The US Federal Reserve has now purchased assets worth $2.8 trillion (and rising) in five years. During the same period, foreign investors bought $2.3 trillion worth of these or similar assets. The investor’s asset purchases also shift interest rates too, but not always in the direction favoured by the central banks. As I write it also appears the Fed is struggling to pull back from its monthly purchase of $85 billion of assets using newly generated, inflationary, new money.

To date, the new tools have shown limited and mixed results. It is agreed that the strongest economies are better off than they would have been without them. However, the new tools have not acted strongly on employment levels, and there are still over 27 million unemployed in the G7 group of nations. It follows that these economies are carrying a huge amount of spare capacity. There may be a lower risk of high inflation, but even so, long-term interest rates are increasing. In the USA, some bond yields have risen sharply since May 2013 when it was hinted by the Federal Reserve that it wanted to slow the pace of bond-buying.

Market rates for bonds have also risen in Britain too, not being curbed by the Bank of England’s provision of “forward guidance”. Rising bond rates are exactly what the central bankers wanted to avoid as they may severely impede the green shoots of recovery as they try to take hold. Perhaps a more skilful use of the shiny new tools is called for!

Both the Bank of England and the Federal Reserve are giving out signals which are confusing and annoying for traders and investors alike. Hints about so-called “tapering” (slowing the pace of bond buying) while promising that monetary conditions will continue to be loose is bad enough. Combining these signals with vague utterances about forward guidance is hardly likely to encourage large scale investment.

Any commitment by central banks to keep interest rates low should be strong. Unfortunately, the commitments are weak! For example, Britain’s monetary policy committee promised to keep rates low until unemployment falls to 7%. An accompanying list of hedges, caveats and vague “get-out clauses” greatly weakened the promise. Mark Carney, the recently appointed Governor of the Bank of England, weakened the promise even further by referring to the forward guidance as merely a “clarification” rather than a policy change.

The US Federal Reserve would like to keep monetary conditions loose, but is concerned about the emergence of asset bubbles. Meanwhile, the Bank of England is trying to keep interest-rate expectations down, but it fears inflation. Given these confused states within two of our most important central banks, it is hardly surprising that the markets are confused and even more difficult than usual to predict the behaviour of. Both of the central banks need to determine their priorities and to give more bold guidance and promises for the sake of their respective economies if not for us poor traders!