No one said central banking was easy. Central bankers must act based on incomplete information about the state of the economy. Sudden shifts in markets can change key parameters such as the cost of capital, exchange rates or the appetite for risk. Little wonder central bankers’ forecasts for growth and inflation – on which they base their policy decisions often go awry.
If that were not enough, in recent times central bankers have decided to offer increased transparency about their policies, even forward guidance. It wasn’t always that way. In Alan Greenspan’s days the ‘maestro’ prided himself on obfuscation. In even earlier times, central banks didn’t even announce policy changes – they let markets infer a policy shift via difficult-to-determine changes in bank reserves.
Openness and clarity of message are both easier and more useful the further the economy is from equilibrium. In that case, it is pretty clear what must be said and done. For instance, following the global financial crisis and confronted with the genuine risk of deflation, the Fed and other central banks stated in no uncertain terms what they were going to do and for how long. They could even credibly pledge to do ‘whatever it takes’.
But transparency becomes trickier once the economy moves back to full employment and price stability. And it becomes potentially problematic once monetary policy has been edged toward a ‘neutral’ setting, as is increasingly the case for the Fed today.
After all, no one – not even central bankers – knows where ‘full employment’ resides. Nor do we or they know when and how quickly the relationship between fuller employment and accelerating wages and prices – the Phillips Curve – might re-asset itself. Equally, we can only guess what the ‘neutral rate of interest’ is – the span of estimates is at least 150 basis points. Moreover, it is dubious that ‘neutral’ applies solely to policy rates. Central bankers will need to also consider the shape of the curve, corporate bond spreads, mortgage rates and broader financial conditions when determining when ‘enough is enough’.
Which brings us back to transparency and, in particular, this week’s Federal Open Market Committee (FOMC) meeting.
By a wide margin, investors anticipate a further quarter point hike from the Fed on 26 September. But what interests them is not what the Fed does, but rather what it says.
And that is where the Fed is most prone to a stumble. Following a series of rate hikes that will have brought the federal funds rate to 2% by this week, the Fed – on some accounts – will be entering the ‘zone of neutrality’ – a policy stance that is neither accommodative nor restrictive. Against the backdrop of inflation near its target, yet not convincingly accelerating, the FOMC might be hesitant to provide assurance about a series of hikes to follow. Some FOMC members may waffle given the rising drumbeat of protectionism, which threatens growth not just via weaker international trade but potentially by damaging business and consumer confidence.
Yet the economy continues to grow above trend. Job formation is well above the natural rate of growth of the labour force. Surveys point to shortages of qualified workers. Fiscal policy is expansionary. And financial conditions remain accommodative, highlighted by a soaring US stock market.
In short, it is becoming more difficult for the Fed to say with confidence what it foresees doing over the next six months, much less beyond. Yet Fed Chairman Powell prides himself on clarity of communication, shunning economists’ vernacular for plain English. And markets crave clarity and guidance.
So what gives? Don’t be surprised if the Fed wavers ever so subtly this week, introducing a bit more ambiguity about the policy path. At the same time, it would be wrong to characterise reluctance of the Fed to commit to medium-term rate hikes as a ‘dovish’ turn. Rather, investors ought to see such a move as the natural progression of the monetary policy cycle. We’ll soon enter the zone of monetary policy uncertainty. We should get used to it.