Mon, Oct 14, 2013 - Page 9 News List

Central banks risk stability by saying too much

‘Forward guidance’ was intended to guide investors by informing them in advance of monetary policy shifts, but it has made markets uncertain and investors lazy

By Marcel Fratzscher

These drawbacks apply to central banks’ forward guidance generally, and are leaving them hostage to fortune. The recent failure of the Bank of England’s guidance to move markets in the desired direction might mean that investors are more optimistic about the British economy. Or it might mean that central-bank guidance was ineffective, jeopardizing the bank’s credibility. The European Central Bank faces similar risks.

For central banks, planning the exit from an accommodative policy stance is less important than exiting their current communication strategies. They should start withdrawing from their overly explicit policy commitments and attempts to micro-manage financial markets. Specifically, they should stop giving forward guidance, including announcements about when they will begin to tighten monetary policy and by how much. They need to reintroduce true two-way risk, so that asset prices again reflect underlying fundamentals.

Rather than trying to nudge investors toward certain outcomes and explicit numerical targets, Yellen and other central bankers need to communicate more clearly how they think about risks and opportunities in the economy and financial markets, and then let private investors decide the balance of risk and reward for themselves. This would help markets become more self-sufficient and resilient, thereby enhancing financial stability and providing support for economic recovery.

Marcel Fratzscher, a former head of international policy analysis at the European Central Bank, is president of the German Institute for Economic Research and a professor of macroeconomics and finance at Humboldt University in Berlin.

Copyright: Project Syndicate

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