Draghi to Carney Face Test Backing Guidance on RatesSimon Kennedy and Stefan Riecher
As governor of the Bank of Canada, Mark Carney hailed a willingness to “put our money where our mouths were” as a reason his 2009 campaign to manage interest-rate expectations paid off.
The test for Carney, now head of the Bank of England, and European Central Bank President Mario Draghi is whether they’ll need to do the same as they introduce so-called forward guidance in the hope they can boost economic growth by restraining the borrowing costs charged in financial markets.
After Carney’s debut meeting on July 4, the BOE told investors that bets on future interest rates were “not warranted,” and hours later the ECB pledged low rates for an “extended period.” Policy makers may have to back up those words guiding financial markets on the path of borrowing costs with action, or risk investors questioning their commitments by pushing up yields.
“Once you have tried forward guidance it’s very hard not to get to dragged into doing more, if not acting then in doing more transparency,” said Gilles Moec, co-chief European economist at Deutsche Bank AG in London and a former Bank of France official. “It’s hard just to maintain vague verbal intervention.”
That’s been a recent lesson for central bankers worldwide who have embraced greater communications as a stimulus tool amid weak economic expansion. Carney’s pioneering forward guidance in April 2009 -- a pledge to keep Canada’s key rate at a record low until mid-2010 -- was paired with an extension of liquidity operations totaling almost C$30 billion ($29 billion), although it didn’t conduct quantitative easing.
Others have gone even further. Draghi’s July 2012 promise to do “whatever it takes” to save the euro was reinforced in September by his creation of a yet-to-be deployed unlimited bond-buying program, dubbed Outright Monetary Transactions.
In the U.S, the Federal Reserve’s forward guidance has evolved from an “extended period” commitment to specific time frames and now unemployment and inflation parameters, with such pledges supplemented by asset-buying. The Bank of Japan has set an inflation target of 2 percent inflation in two years as it doubles the monetary base.
According to Rob Wood, chief U.K. economist at Berenberg Bank in London, without action there is little guarantee for investors that central banks won’t change their minds later.
“If you just talk a good game the only cost to reversing your decision down the line is reputation,” said Wood, a former BOE economist, who noted U.S. markets are already skittish now the Fed is hinting it will peel back its monetary aid.
Sweden’s Riksbank provides a case study because its experience shows “it would be wrong to expect explicit forward guidance to have profound impact on financial markets and the behavior of firms and individuals,” Ben May, an economist at Capital Economics Ltd. in London, said in a report today.
Since 2007, the Riksbank has published a forecast of its main rate. While such transparency has helped manage expectations, it has been misinterpreted at times by investors due to differences in perceptions of the economic outlook.
“Central banks wishing to take bolder action to support their economies should not rely solely on this form of forward guidance to lower interest-rate expectations and boost domestic demand,” said May.
Both the ECB and BOE are talking more amid pressure to decouple their markets’ borrowing costs from the upward pull of U.S. yields, which have risen as the Fed signals it may soon start to taper its $85 billion-a-month asset purchase program.
The yield on the 10-year U.S. Treasury rose to 2.75 percent on July 8, the highest in almost two years, from as low as 1.61 percent in May. It was at 2.48 percent today.
Fed Chairman Ben S. Bernanke’s comments on June 19 that the Fed may start dialing down its bond-buying program also sent yields spiraling higher in Europe’s debt-striven periphery, with Portugal’s 10-year yield climbing above 8 percent on July 3 for the first time since November. In the U.K., the 10-year gilt yield has risen to 2.26 percent from 2.08 percent a month ago.
“Very clearly, the normalization of monetary policy in the U.S. which is ahead and on the agenda of the Fed, will impact Europe,” former Bundesbank President Axel Weber, now the chairman of UBS AG, said in a July 12 Bloomberg Television interview. “It’s coming for Europe at an awkward point in time.”
At the ECB, policy makers have been hesitant to give any details on how long an “extended period” of low rates could be, leading to some confusion. Executive Board member Joerg Asmussen said last week in an interview with Reuters TV that “it is not six months, it is not 12, it goes beyond,” only to be corrected by an official clarification shortly after, that no exact length was given.
Executive Board member Benoit Coeure told Bloomberg News on July 11 that the ECB will reassess its signalling every meeting. The same day, Bundesbank President Jens Weidmann even spoke of the need to raise interest rates if required to curb inflation as he said the ECB has not “tied itself to the mast.”
“The ECB just gave guidance on what everyone expects anyway,” said Richard Barwell, senior European economist at Royal Bank of Scotland Group Plc in London.
While markets may not test Draghi “for fundamental economic reasons, they may well test him if we have some more contagion from the U.S.,” he said. “That then is a real test for the ECB.”
Such a challenge could require the central bank to flesh out its communications further to give markets greater insight into how strong its commitment is, said Laurence Boone, chief European economist at Bank of America Merrill Lynch.
ECB officials could extend the time they try to deliver inflation just below 2 percent from the current “medium term,” define that target more precisely or provide more detail on their thinking by issuing minutes or agreeing to speak more harmoniously. Setting thresholds as the Fed did is harder because there are 17 euro-area nations with different labor markets, while the ECB lacks an employment mandate.
Philippe Gudin, chief European economist at Barclays Plc in London and a former French government official, said the ECB may need to take steps such as introducing new longer-term refinancing operations or lowering the benchmark rate closer to zero from 0.5 percent. Draghi says he has an “open mind” on whether to cut again.
“At some point they will need to do more to convince the markets,” said Gudin, who sees a 30-40 percent chance of a rate reduction by the end of the year.
While the ECB hasn’t indicated yet whether it will broaden its telegraphing, the BOE is already looking to do more, after Carney and colleagues used his debut meeting this month to issue a statement saying investors had priced in higher rates earlier than they should.
They are now working on a report due next month on whether to embrace Fed-style forward guidance to govern rate increases, which they said will have an “important bearing on the committee’s policy discussions in August.”
Carney’s first meeting ended with officials voting unanimously to keep their 375 billion-pound bond-buying program on hold, though a minority said stimulus was still warranted. For those policy makers, the guidance report “would shed light on both the quantum of additional stimulus required and the form it should take,” according to minutes released yesterday.
Carney will align the BOE with the Fed by tying rates to economic developments, according to 23 of 43 economists surveyed by Bloomberg News this month. Eighteen said the bank will follow Canada in using a time period.
While the case for doing so is diminishing as the economy strengthens, the bank may still need to reinforce its words with action if markets doubt its commitment, said David Tinsley, chief U.K. economist at BNP Paribas SA in London.
“Guidance flattens out the yield curve,” he said. “There’s a question whether that’s sufficient to achieve objectives of stabilizing output volatility and hitting the inflation target. If it isn’t you can do gilt purchases.”