In the past few weeks, several central banks have raised their interest rates more than they had previously announced. The old maxim of protecting the markets from surprises no longer applies. The days of forward guidance are numbered – finally.
Christine Lagarde, President of the European Central Bank, and Jerome Powell, Chairman of the US Federal Reserve, recently surprised both with unexpectedly large interest rate hikes.
In recent years, many central bankers have behaved like overprotective shepherds. They took the public and the markets gently by the hand and tried to protect them from unpleasant surprises. In order to nip any form of nervousness in the bud, the audience was given the clearest possible indication of how monetary policy was to be shaped in the near or distant future, for example with a view to the development of key interest rates or the purchase of assets. According to the motto, one’s own actions should be as predictable as possible.
Forward Guidance – a losing battle
The magic word that describes this guide is forward guidance. It stands for a communication policy in which a central bank undertakes, for example, to leave the key interest rates untouched until a certain period of time has elapsed, inflation is above 2 percent or some other event has occurred. It is therefore a matter of self-commitment: one’s own monetary policy flexibility is exchanged for the hope that the markets will be managed intelligently.
This concept, which has been used in the US since the 2000s and in the euro area since 2013, has recently started to falter. In June, for example, the American Federal Reserve (Fed) increased its key interest rate by 0.75 percentage points after Fed Chairman Jerome Powell had practically ruled out such a jump a month ago. This Thursday, the European Central Bank (ECB) doubled its interest rate hike by 50 basis points, although the ECB had announced a step of only half the size a month earlier.
Some investors are now shouting “Foul!” and criticize that the central banks no longer stuck to their announcements. But it’s a losing battle. Gone are the days of forward guidance, which works easier when inflation is low than when it is high. ECB President Christine Lagarde made that clear this week. With a view to possible rate hikes in September, she emphasized that no guidance was to be expected from the ECB. So you are more flexible; in the future, decisions will be made from meeting to meeting, based on the data.
Investors should tremble again
The behavior of the central banks is thus becoming less transparent and more difficult to calculate. Is that a step backwards? no It is high time that investors began to tremble again and that they were no longer immune to the risk of interest rates rising or falling. The de facto elimination of such risks by a central bank, whose forward guidance acts like free insurance, has led to an exuberant willingness to take risks in recent years; the financial markets became more dangerous instead of more stable.
Central banks were not created to reassure investors. Rather, they should ensure stable prices. Flexibility is required to fulfill this task. After all, the economic environment – as the past few years have shown – can change quickly. Then it is important to react quickly, regardless of promises from times when the world looked different. If central banks don’t do this, they miss out on important changes, such as an unexpected surge in inflation.
This is the trap that the Fed and the ECB have fallen into. In order not to thwart their own forward guidance, they reacted far too late to inflation and stuck to the narrative that high inflation was only a temporary problem. If, as a result of this misjudgment, the idea of strict forward guidance is buried, that is to be welcomed. For monetary policy, credibility is more important than predictability. And credibility is not gained with multi-year projections, but with stable prices.