Central banks ending era of clear promises, return to 'artful' policy

NEW YORK/TOKYO — The world's major central banks are returning to a more opaque and artful approach to policymaking, ending a crisis-era experiment with explicit promises that they found risked their credibility and did not substitute for action.

From Washington to London to Tokyo, the global shift from transparency to flexibility underscores the challenges central bankers face as they test the limits of what monetary policy can achieve.

The return to a more traditional policymaking approach and nuanced statements will challenge the communication skills of central bankers who have been chastened in the last year after some too-specific messages confused and disrupted financial markets.

Complicating things on the world stage, the US Federal Reserve (Fed) and the Bank of England (BoE) are looking to telegraph plans and conditions for raising interest rates, while the European Central Bank (ECB) and the Bank of Japan (BoJ) are heading the other way.

"Central banking used to be an art," said a senior official of a Group of 7 central bank. "It became less so once, globally, but with what's happened at the Fed and the BoE, it may be back to being an art."

Both the Fed and BoE had promised to hold interest rates near zero until their jobless rates had fallen to a particular level. However, unemployment in the United States and Britain fell much more quickly than economists expected and both central banks scrambled to replace their suddenly outdated "forward guidance".

"Too much transparency may sometimes be counter-productive. The balance is always tricky," the official added, requesting anonymity.

The plan had been novel. After driving short-term borrowing costs to historical lows to battle the 2007-2009 financial crisis and deep recessions, Western central banks began offering pledges on the future rate path in an attempt to pull down long-term borrowing costs for automobiles, homes and business expansion.

Fed Chair Janet Yellen and many other policy makers routinely say the plan succeeded on that score, although other factors contributed. But Yellen, who was vice chair of the US central bank before taking the Fed's reins, is leading the charge away from specific policy forecasts.

"The idea of forward guidance was that by being transparent, you got a bigger effect on long-term rates," said Patrick Artus, global chief economist at French bank Natixis.

"But central banks take a risk on credibility," he added. "If something unexpected happens, you have to deviate from what you have been announcing."

The Fed's reputation took a hit last spring when borrowing costs shot up after then Fed chairman Ben Bernanke talked about the prospect of the central bank reducing its stimulative asset purchases "in coming meetings". Emerging markets also sold off sharply as investors priced in an earlier liftoff for US rates.

Several Fed officials felt compelled to walk back the guidance in an episode that prompted criticism from around the world over the Americans' sloppy communications.

The BoE, too, struggled with communication. In February it was forced to reconsider policy two and a half years ahead of schedule. With caveats about the economy, it had promised to keep rates low at least until the unemployment rate fell below 7 per cent, predicting that would take three years. It took six months.

A month after the BoE's reconsideration, in March, the Fed would drop a similar pledge.

The experiences, keenly scrutinised and debated, led to a growing realisation of the dangers of offering policy commitments, said officials familiar with discussions among global central bankers.

"We have to be careful [and] certain that you do not commit to things that we're not sure we can actually produce," Alan Greenspan, Bernanke's predecessor, told the Economic Club of New York in April. "Remember, we don't forecast very well."

From 'cheap talk' to 'useful guidance'

The latest guidance from the Fed and BoE is far less specific.

After Yellen's first policy-setting meeting as Fed chair in March, the US central bank said rates would likely stay at rock bottom for a "considerable time" after it shelves its bond-buying programme and, in a twist on qualitative guidance that leaves the Fed flexibility, it predicted rates would stay below-normal even after the economy has fully healed.

Yet Yellen sent markets tumbling when she stepped out of the Fed meeting that day and told reporters rates could rise "around six months" after a bond-buying programme ends.

Since then, by and large, the Fed has stuck with its broader guidance, closing the book on an era in which it rolled out eight distinct messages since 2008 on when it planned to tighten policy — at times targeting dates, at other times targeting specific unemployment and inflation rates.

The Fed is now moving away from "cheap talk" and towards "useful guidance", said Adam Posen, a former member of the BoE's policy-setting committee who is now president of the Peterson Institute for International Economics.

"It doesn't commit you to anything, or constrain you in terms of what you are responding to," he added.

Similarly, BoE Governor Mark Carney has refused to give any clear indication of the timing of a rate hike in recent appearances, instead steering markets to scrutinise both the strength and uncertainties of the economy.

But he too has struggled to sound the right tone: Investors scrambled to adjust their bets in June after Carney said they underestimated the chance of an early rate hike. He sought to soften the comment the following week, prompting one lawmaker to compare him to an "unreliable boyfriend."

Walk the talk

The example of Japanese and European central banks show that verbal commitment could prove ineffective unless backed by bold action.

The BoJ historically favoured opacity over transparency, but its approach failed to pull Japan out of deflation for nearly two decades.

Haruhiko Kuroda, a central banking outsider who took the BoJ's helm in March of last year, married bold action and words when he pledged to hit the bank's 2 per cent inflation target in roughly two years, and the BoJ doubled its aggressive asset purchases.

The double-whammy weakened the yen by 8 per cent against the dollar and lifted consumer inflation about half way to the BoJ's goal.

Even so, Kuroda has responded by following up with vague guidance, saying only that the BoJ will stick to ultra-loose policy until 2 per cent inflation is achieved in a "stable manner". So far markets do not expect a premature change in policy.

As for the ECB, it faces perhaps the greatest test as it struggles to extinguish deflation risks. After spending most of last year teasing financial markets about pending action, it had to put its money where its mouth was in June by adopting negative interest rates.

ECB President Mario Draghi has said more action would come if necessary although it is uncertain how long he can wait without launching a bond-buying programme, known as quantitative easing or QE, which is the last big option left in the bank's depleted war chest.

"There are a lot of people in central banks who are fantasising about forward guidance because it means they can stop QE and still claim they are doing something," said Posen of the US-based Peterson Institute.

"It was very attractive because... it doesn't cost us anything," he added. "And like most things that don't cost anything, it's not worth much."