Managing expectations

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.

Interpreting Monetary Policy Communication

In my post “Watching the Central Bankers”, we cover the various ways in which central bankers communicate their thinking to market participants. But the process is far more nuanced and evolved than relying simply on official policy statements or speeches before the Rotary Club of Indianapolis. Central bankers are keenly aware that their comments have the ability to move, and potentially disrupt, financial markets all over the world. So they choose their words very carefully, leaving traders to act as interpreters. Before you start interpreting monetary policy statements and commentary, it’ll help to know the following.

Not all central bankers are created equal

The interest rate setting committees of central banks, frequently known as Monetary Policy Committees (MPCs) - the Fed's FOMC is one of these typically operate under a one-member/one-vote rule. But when it comes to delivering a message to the markets, the chairman or president of the central bank holds far more sway than any other individual member. This is partly in deference to the central bank chiefs role as first among equals, but also because that person is frequently viewed as expressing the thinking of the entire committee. Central bankers strive for consensus in reaching their decisions, and who better to represent and present this view than the chairman or president?

When the head of the central bank gives an update on the economy or the outlook for interest rates, listen up. A scheduled speech by the chair of the Fed, for instance, is likely to be preceded by market speculation similar to that of a major economic data report. And the reaction to his comments can be equally sharp.

In the case of the Fed, the FOMC is comprised of 12 voting members consisting of the board of governors and a rotating slate of regional Federal Reserve Bank presidents each year. So when a Federal Reserve Bank president is set to speak, make sure you know whether he‘s a voting member in the current year before acting on his comments.

Remarks by non-voting FOMC members are frequently discounted or ignored by traders because the speaker is not going to be casting a vote at the next meeting. But this is a bit of an oversimplification and can be risky. Before downplaying a non-voter’s comments, you need to consider her comments in the context of the FOMC consensus. Is she expressing her own views or elaborating on a shift in consensus thinking?

Birds of a feather: Hawks and doves

Central bank officials are frequently a known commodity to market analysts and traders, either from past policy statements or from their academic or policy writings prior to becoming central bankers. Markets typically refer to central bankers in terms of being hawks or doves. A hawk is someone who generally favors an aggressive approach to fighting inflation and is not averse to raising rates even if it will hurt economic growth. A dove, on the other hand, is a central banker who tends to favor pro-growth and employment monetary policy, and is generally reluctant to tighten rates if it will hurt the economy. In short, hawks tend to be fixated on fighting inflation, and doves tend to stress growth and employment.

Don’t get me wrong: There are plenty of central bankers in the middle who can wear both hats (and feathers, in this instance). In those cases, the middle-of-the-roaders tend to reveal their hawkish or dovish leanings only at the extremes of the policy cycles.

So if a hawk is slated to speak on the outlook for monetary policy, and he cites the risks from inflation or the need to prevent any increase in inflationary pressures, guess what? You’re not going to see much of a reaction from the markets because he’s a known quantity speaking true to form. You get a much sharper reaction when a hawk downplays the threats from inflation or suggests that inflationary pressures may be starting to recede. Markets will jump all over dovish comments coming from a hawk, and vice versa with hawkish comments made by a dove. 

Watching the central bankers

If you've read my previous post, you've probably gotten the impression that determining monetary policy is mostly an exercise in shades of gray rather than a simple black-and-white equation-and you’d be exactly right. But given the significance of monetary policy to currencies, currency traders devote a great deal of attention trying to divine the intentions of central bankers. This has not always been an easy task, but recent trends among central banks to improve the openness of communications with markets, frequently referred to as transparency, have made the process less of a guessing game.

Central bankers communicate with the markets in a number of ways, and their comments can provoke market reactions similar to major economic data releases - by that, I mean sharp initial price movements followed by continued volatility or a potential change in direction.

• Rate decisions: Interest rate setting committees of central banks meet at regularly scheduled times. At the conclusion of a meeting, they issue a formal announcement of the policy decisions made at the meeting. They can raise,  lower or hold interest rates steady. They can also make changes to reserve requirements or liquidity operations.
• Policy statements or guidance: Along with the interest rate decision, central banks frequently issue an accompanying statement that explains the basis for their policy action. These statements are also used to provide guidance to markets on the future course of monetary policy. The statements are carefully parsed by markets intent on discovering what the central bank is thinking, which way it's leaning, and what the timing may be for future changes. Rate announcements and accompanying policy statements are included on economic data/event calendars.
• Public speeches: Central bankers frequently appear before community and business groups, and address subjects ranging from trends in the financial industry (such as the rise of hedge funds or the use of derivatives) to relatively mundane governance issues (such as financial reporting requirements). But when a central banker gives a speech that assesses the economic outlook or the future course of monetary policy, forex markets are all ears.

Appearances by central bank officials typically are included on most economic event/data calendars, and you need to be aware of them to avoid being taken by surprise. Sometimes, the topic of the speech is given in advance; other times, it’s not. The most important speeches are those that focus on the economic outlook or the current monetary policy assessment.

In most cases, a prepared text is released by financial newswires at the scheduled start time of the speech. Accredited news agencies receive copies of speeches in advance to allow their reporters to prepare stories and headlines, but the release of the information is embargoed until the designated time. The remarks are then encapsulated into a series of headlines that capture the main points of the speech; this is the news that markets receive at the appointed time. When these headlines hit traders’ screens, market prices start to react. If a question and answer session follows, the central banker’s comments will be posted by the newswires as they’re delivered live. This setup can make for some exciting headline-driven trading.

In following monetary policy developments, market participants essentially operate under a fluid, constantly evolving model of expectations of where monetary policy and interest rates are heading. The biggest market or price responses come in reaction to unexpected changes to or shifts away from the prevailing expectation. For example, a central bank may be in the process of progressively tightening monetary policy in response to stronger growth or rising inflationary pressures, and traders will take market positions based on this outlook for higher interest rates. When these central bank officials make comments in line with the prevailing view, there is little reaction to market prices. But when these central bankers signal a shift in thinking, the reaction can be fast and furious. Continuing with the preceding example, if a central bank official signals in a speech that he thinks inflationary pressures are beginning to recede, the prevailing market wisdom is turned upside-down. Suddenly, higher interest rates are no longer assured - positions are reduced or exited entirely, and new positions betting on steady to lower interest rates may be opened.

Usually, it’s not too difficult to tell the overall direction of monetary policy, whether interest rates are going up or down. This is especially true in recent years, as central banks try to communicate their views more openly to markets in the name of transparency. So the question usually boils down to the timing or size of changes to interest rates. Will the Fed tighten at the next meeting or wait to gather more information? If inflation is seen to be accelerating, will the Fed feel compelled to hike by more than 25 bps? So traders clue in to every piece of data and every comment by Fed officials to gauge the size and timing of the next move. Subtle shifts in language or turns of phrase by a Fed speaker can generate sharp price moves as market participants interpret their comments and react in the market.

Currency traders need to be aware of and constantly follow the current market thinking on the direction of interest rates because of the strong relationship between interest rates and currency values. The best way to do this is to follow market commentaries in print and online news media, always keeping in mind that such outlets (especially print) are usually one step behind the current market. This makes online news commentaries that much more relevant. Some of the best sites for timely insights and market reporting are Bloomberg.com, Reuters.com, and MarketWatch.com. Best of all, these sites are free. Look for currency brokers that offer real-time market analysis and news updates.

Identifying monetary policy cycles

Changes in monetary policy usually involve many small shifts in interest rates, because central bankers are increasingly reluctant to shock an economy by adjusting interest rates too drastically. Even the potential for large interest rate changes could contribute to uncertainty among investors and businesses, potentially disrupting or delaying well-laid business plans, harming the overall economy in the process. Typical interest rate changes among the major central banks center on 1/4 percent or 25 basis points (a basis point is 1/100th of 1 percent, or 0.01 percent), with 50 bps (or 1/2 percent) as the next most frequent rate adjustment.

In recent years, 50 bps adjustments have primarily been used in extreme situations, such as during the Asian financial crisis/Russian debt default/Long Term Capital Management (LTCM) collapse of 1998. Talk about a bad year. In early 2001, 50 bps rate changes were employed as the dot-com bubble burst and in the aftermath of 9/ 11 a bad year unlike any other. So unless-circumstances are extreme or urgent, or a central bank has fallen hopelessly behind economic events, 25 bps moves are the norm.

Adjustments to monetary policy and changes to interest rates usually play out over extended periods of time, ranging from quarters to years. In the first place, it takes time for central bank policy makers to accumulate sufficient economic data to make judgments about when and by how much interest rates need to be adjusted. There is also a time lag between when interest rates are changed and when they affect business or consumer behaviour. The time is usually estimated at 12 to 18 months but may be as long as 24 months.

The life of a monetary policy cycle

To give you a better understanding of how monetary policy cycles work, look at the following case, where an economy is emerging from a period of very low or negative growth over an extended period of time. We start from then low point of the interest rate cycle.

In response to the economic downturn, the central bank had lowered interest rates to a level it deemed “stimulative” or low enough to rejuvenate growth by stimulating borrowing and investing.  After many months in a low interest rate environment, and as incoming economic data reports point to expanding economic activity and growth rates, the central bank may decide to remove some of the policy stimulus by raising interest rates. This first interest rate hike following a series of cuts represents the beginning of a cycle of tighter monetary policy. The overall level of interest rates may still be considered “accommodative” in relative or historical terms but some of the accommodation has been removed. Assuming economic growth continues to build strength, the central will progressively hike rates further, removing remaining accommodation.

Somewhere along the way, the central bank will reached an equilibrium interest rate level representing a “neutral” monetary policy. In theory, a neutral monetary policy is one-in-which interest rates are neither stimulative nor restrictive. In real terms, though, it’s nearly impossible to pin down exactly what constitutes a neutral interest rate level. A neutral level of interest rates will change over time as an economy evolves - what may have been neutral in the last cycle is now considered restrictive. As a result, central bank officials and economists tend to talk about a range of interest rates that may represent policy neutrality - say, something like 5 percent to 5.5 percent.

If economic data indicates that growth is beginning to slow or decline, the central bank is likely to stop hiking rates and wait for a period to determine how the economy is responding. This interest rate outlook is frequently referred to as a neutral bias. It may be the peak in the current tightening cycle, or it may just be a brief pause - only time and the economic data will tell. Central banks also refer to this as a balanced outlook, meaning that the risks to growth and inflation are roughly even.

If growth picks up steam again, or if inflationary pressures become evident, the-central bank is likely to increase benchmark interest rates further, pushing monetary policy into a restrictive zone. From the growth side of the picture, a restrictive monetary policy seeks to restrain or slow economic growth by increasing the costs of borrowing. At the consumer level, higher interest rates begin to shift the incentives from borrowing and spending toward saving and investment, reducing personal consumption and contributing to slower economic growth.

This cycle continues until the economy weakens sufficiently or inflationary pressures subside enough or some combination of both, to cause monetary policy to reverse direction. And the potential scenarios are many. Growth could slow, but inflation could remain elevated. Growth could level off, and inflation could fade. Growth could accelerate along with inflation.

The specter of inflation

In terms of inflation, higher interest rates are a signal from the central bank to businesses and markets that further price increases are undesirable and will be met with higher interest rates. For better or worse, central bankers consider themselves the guardians of economic and price stability, and nothing is more alarming to them than inflation above tolerable levels, typically cited as about 2 percent to 3 percent annually. Given the inflation mandates of some central banks, interest rates may be forced ever higher by inflation, choking, off growth in the process and leading to a downturn in the economy.

Credibility is the watchword here. A central bank's credibility is based on markets’ perceptions of the central bank’s willingness to combat inflation, even if it means causing an economic downturn. This situation is the worst-case scenario for a central bank and essentially is what happened to the U.S. economy in the late 1970s and early 1980s. In the process, however, Fed Chairman Paul Volcker proved highly credible in his commitment to defeating inflation and set the stage for a more credible Fed policy under Alan Greenspan. The Fed’s enhanced credibility with markets paved the way for significant periods of growth in the ensuing decades, with only minor outbreaks of inflation that were quickly extinguished. 

Because monetary policy acts with a time lag, central banks need to be proactive and forward looking. Estimates from the Fed itself are that monetary policy changes carry a 12- to 18-month time lag. That means that rate changes made today may begin to affect the economy only in about a year’s time. By the time economic growth is considered strong enough to stoke inflation, for example, it may already be too late for a central bank to head off future price increases. Inflation may already be in the pipeline, and higher prices are looming. To get around this, central bankers rely on economic forecasts and models to guide their policy decisions.

But central bankers can hardly escape the day-to-day messages coming from current economic data and market signals. Sharp increases in the unemployment rate can generate tremors in the economy, sending consumer sentiment plunging. (Rising unemployment rates can increase feelings of job insecurity restraining personal spending.) On the flip side, declines in the unemployment rate can signal a shortage of labor, creating fears of wage-driven inflation. (As the labor force becomes tighter, workers are supposedly able to demand higher wages.) Each suggests a different monetary policy direction. Taken together, monetary policy decisions are based on both current data and expectations for growth and inflation.

Monetary Policy 101

Monetary policy is the set of policy actions that central banks use to achieve their legal mandates. Most central banks function under legislative mandates that focus on two basic objectives:

• Promoting price stability (a.k.a. restraining inflation)
• Promoting sustainable economic growth, sometimes with an explicit goal of promoting maximum employment

Although it's a no-brainer that promoting economic growth is more important to those of us who work for a living, central bankers like to focus primarily on inflation. Low inflation fosters stable business and investment environments, so central bankers see it as the best way to promote long-run economic growth. Low inflation is also an end in itself because high inflation erodes assets and undermines capital accumulation. Some central banks, such as the European Central Bank (ECB), have only one mandate - to ensure price stability - with other policy objectives (growth and employment) explicitly relegated to secondary status. Still other central banks - the Swiss National Bank, for example - have a mandate to ensure a stable currency, though most countries have delegated that responsibility to the national finance ministry/treasury department.

Looking at benchmark interest rates

The primary lever of monetary policy is changes to benchmark interest rates, such as the federal funds rate in the United States or the refinance rate in the Eurozone. Changes in interest rates effectively amount to changes in the cost of money, where higher interest rates increase the cost of borrowing and lower interest rates reduce the cost of borrowing. The benchmark rates set by central banks apply to the nation's banking system and determine the cost of borrowing between banks. Banks in turn adjust the interest rates they charge to firms and individual borrowers based on these benchmark rates, affecting domestic retail borrowing costs. Other tools in the monetary policy toolkit used by central bankers are

• Changes to money supply: The overall amount of money in circulation, or the greater the money supply, the lower the cost
• Reserve requirements: The amount of capital required to be-set aside by the banking system; money that cannot be used for lending

Easy money, tight money

The main thrust (or bias, as markets call it) of monetary policy generally falls into two categories: expansionary and restrictive. An expansionary monetary policy aims to expand or stimulate economic growth, while a restrictive bias aims to slow economic growth, usually to fight off inflation.

Expansionary monetary policy

Expansionary monetary policy (also know as accommodative or stimulative monetary policy) is typically achieved through lowering interest rates (that is, reducing the costs of borrowing in the hope of spurring investment and consumer spending). Cutting interest rates is also known as easing interest rates and is frequently summed up in the term easy monetary policy. Central banks can also increase the money supply - the overall quantity of money in the economy - which also works to lower borrowing costs. A reduction in the reserve requirement of banks frees up capital for lending, adding to the money supply and reducing borrowing costs as well.

An expansionary monetary policy is typically employed when economic growth is low, stagnant, or contracting, and unemployment is rising. An easier monetary policy can also be introduced in response to major shocks to the financial, economic system, such as that following the September 11, 2001, terror attacks in the United States or the bursting of Japan’s “Bubble Economy” in the early 1990s.

Restrictive monetary policy

Restrictive monetary policy (also known as contractionary or tighter monetary policy) is achieved by raising, or “tightening,” interest rates. Higher interest rates increase the cost of borrowing, and work to reduce spending and investment with the aim of slowing economic growth.

Central banks typically employ a tighter monetary policy when an economy is believed to be expanding too rapidly. The tear from the central banker‘s perspective is that heightened demand coupled with the low cost of borrowing may lead to inflation beyond levels considered acceptable to the long-run health of an economy. With too much money chasing the same or too few goods, prices begin to rise, and inflation rears its ugly head. Rapid wage gains, for example, may lead to increased personal consumption, driving up the cost of all manner of retail products.