The nomination of US Federal Reserve Vice Chairman Janet Yellen to succeed Fed Chairman Ben Bernanke comes at one of the riskiest moments in the recent history of the Fed. The Fed’s announcement in May that it might start tapering its long-term asset purchases surprised many central bankers, and triggered a sell-off from markets worldwide. However, some of the good news about the US’ economy was bad news for financial markets, because investors considered the Fed’s potential policy tightening in response to such news to be more relevant than the news itself.
Then, last month, when the Fed postponed its withdrawal from so-called quantitative easing, markets quickly turned euphoric. Indeed, investors today appear less concerned about the real economic story than about the Fed’s interpretation of it. This underscores an important risk that Yellen must now reckon with as she guides US monetary policy: In the longer run, the dominance of the Fed’s views in the market may cause serious economic harm.
The problem for the Fed and other central banks lies not in monetary accommodation, but in their communication strategies. Their extensive promises, assurances and pre-commitments have lured market participants into a false sense of security. This has induced market players to take on the wrong types of risk, leaving them poorly prepared for adverse changes in the economy and posing a broader threat to long-term financial stability.
Central banking is all about managing market expectations. Monetary authorities have, in recent years, made the way they communicate — about their thinking and possible actions — their primary tool to guide markets and anchor expectations. This is especially true of so-called forward guidance on policy rates — and increasingly so as central bankers’ scope for policy action has become more limited.
Unfortunately, major risks and costs arise from over-reliance on communication strategies. Because the voice of central banks has become so dominant in financial markets, price movements have come to reflect responses to their statements and actions, rather than to changing economic and financial realities.
For example, when policymakers promise to act if certain risks arise, markets inevitably discount the impact of such risks. In May, Bernanke issued an unusually stern warning about excessive risk-taking in financial markets. Yet investors have pushed equity indices to all-time highs, despite the feeble and uncertain recovery, while the Volatility Index, a proxy for investors’ perceptions of risk, fell to levels not seen since the boom years of 2005 and 2006.
A second consequence of the dominant role of central banks’ communications in financial markets is that it crowds out private sources of information, thereby depriving the monetary authorities themselves of an invaluable, independent view of trends that they need for sound policymaking. Worse, private actors no longer see the need to collect, analyze or deploy their own information to the extent that they once did.
A third drawback is that when central banks are seen to give misleading assurances and to over commit to certain outcomes, they risk losing their most important asset: their credibility. What will the Fed do, for example, if inflation rises sharply, but unemployment remains high? The Fed’s inability to anchor expectations would not only harm its credibility with investors, but would also make it much harder to fulfill its dual mandate of pursuing price stability and maximum employment.