One of the key roles of central
bankers is to act as stewards of the economy. When it comes to making changes
in monetary policy, central bankers often compare the process to turning around
an aircraft carrier. You can't do it on a dime. It takes a lot of preparation
and a fair amount of time. The same is true of setting monetary policy for
large and complex economies like those behind the major currencies.
Sending
a message
Central bankers understand the
need to prepare economic decision makers for changes in the overall direction
of monetary policy and interest rates. The idea is to give businesses and
investors enough time to make adjustments to their strategies while minimizing
any disruptions caused by changes to interest rates. Think of it this way: If you
were sitting on the fence about whether to refinance your home mortgage, and
the chair of the Federal Reserve started dropping hints that interest rates
need to move higher, you’d probably get off that fence pretty quickly. The same
idea applies to economies as a whole.
As long as the circumstances are
not drastic or urgent, central banks may spend several months preparing markets
and firms for a shift in the overall direction of monetary policy. The time lag
is necessary because central bank policy makers don’t know with certainty what
they’re going to do based on the most recent one or two months of economic
data. They need time for a clearer picture of shifts in the economy to emerge,
as well as time to forge a consensus among committee members.
Recognizing
that timing is everything
Within monetary policy cycles,
central bankers are also increasingly prone to give indications as to the timing of the next change to interest
rates. For example, in the context of a monetary policy tightening cycle, after
deciding to hold rates steady at the current meeting, a central bank may
include language in the accompanying statement signalling that it’s very likely
to raise rates at the next meeting.
This phenomenon is a new one, and
looks to be aimed at preparing markets and investors for coming interest rate
adjustments. The idea is to minimize financial market volatility, which can be
a threat to financial system stability as well as to the overall economy.
Staging
on message
Central banks are able to
directly influence short-term benchmark interest rates only through their
monetary policy decisions. Longer-term interest rates, which affect everything
from home mortgages to corporate loans, are set by the market. From time to
time, the two interest rates may diverge. For example, the central bank may be
attempting to raise borrowing costs, but the market is flush with liquidity
(cash) and opts to push long-term rates lower. Alternatively, after a run-up in
interest rates and a subsequent drop in economic growth, a central bank may
seek to add liquidity and rejuvenate growth by lowering interest rates. If the
market still views the outlook as uncertain, it may keep long-term interest rates
high to compensate for perceived credit risks in the uncertain environment.
When this happens, the central banks’ policy objectives are undermined by the
market.
Central banks are then in the
awkward position of having to redirect market expectations in the direction
favored by the central bank. Apart from abruptly changing short-term interest
rates in the desired direction, central bankers are really left with only one
option: Send a new message to the market to point out the error of its ways.
The transmission of this message typically is accomplished by a number of
speakers from the central bank delivering similar messages in multiple forums
to the market. It’s like a high-stakes game of chicken, and the central bank
hopes the market will blink first. If the market doesn't blink, the central
bank can’t do much apart from adjusting the benchmark rate again.
