Central Bank Communication

For Central Bank geeks, last week was eventful.  The head of both the Federal Reserve and the Bank of Canada took to the podium to explain to the market that they have shifted into “grope” mode.  Both institutions have moved well past the point when appropriate policy was obvious which has generally been the case since 2008.   The huge output gap that opened up in the two countries following the financial crisis required nothing but various degrees of ridiculously accommodative monetary policy.  But now, by historical standards, the two economies are at or near full employment.  The only problem is that inflation has not yet responded as one would expect with the gap closed.  This potentially throws the whole Phillips curve framework that the two banks predominately use for policy determination into question.  The confidence that they once held in this framework is being tested.  In this scenario, it is not surprising that they would shift into “grope” mode as the clarity of the environment they are operating in has become murkier.

This new environment is likely to create a gap between what the market has come to expect from central bank communication and what the central bank can provide.  The level of confidence that the proper policy was in place when it was extremely obvious what policy was needed allowed and even forced the central banks to be extremely transparent and explicit.  In the height of the crisis, it gave birth to the idea of forward guidance where central banks promised to keep rates locked at low levels for specific periods of time or until certain economic criteria had been met.  The market was effectively spoon-fed what to expect when it came to rates so there was no reason for the markets to scrutinize the economic data.  The central bank would do the analysis and then tell the market what was next.  

So this week both central banks were very transparent.  From the speeches, the market heard the Fed say that interest rate increases will continue at a slow pace.  On the other side of the border, the market heard the Bank of Canada put a damper on rate hike expectations apparently to ground the high flying loonie.  But I am not sure the market truly heard the subtleties of what was said.  No doubt the market properly interpreted the most likely interest rate path for both countries but I don’t know if they appreciate that the central banks have much less confidence in the interest rate profile that they are suggesting.   Moreover, given that markets are backward looking, the last ten years would suggest the markets’ portfolio of interest rate profiles is likely biased to the downside.  At the same time, a central bank is suppose to be forward looking which would suggest a set of unbiased rate profiles that will allow them to hit their inflation target that has a greater uncertainty band around it.  This means their menu likely includes profiles where rates could go up much quicker than expected by the market but also includes scenarios where they could just as easily go down.  It will depend on the data!    

After almost ten years of being central bank dependent and not data dependent for front end rate determination, it is not surprising to me that the market is struggling a bit with a central bank that can no longer give them the precision that they crave.  It is unrealistic for a central bank to give the market guidance suggesting one interest rate path, when they are less sure of what the appropriate policy is themselves.  As the confidence bands expand around their forecast for inflation, the number of appropriate possible interest rate paths multiply.