Oh yeah, I’ll tell you something
I think you’ll understand
When I say that something
I want to hold your hand
– “I Want to Hold Your Hand,” The Beatles
Hand-holding is getting to be very popular with the world’s major central banks. Effectively constrained by zero or near-zero interest rates, central banks have been putting greater emphasis on the effectiveness of their communications. Central bank “speak” – if used wisely – holds the power to ease monetary conditions as much as, if not more than, policy rate changes.
The Federal Reserve first introduced hand-holding, which is to say “explicit forward guidance,” in August 2011. At that time, they promised to keep policy rates at exceptionally low levels “at least through mid-2013.” The Fed then went even further in December 2012 and introduced numerical thresholds for its policy guidance. That level of hand holding has helped ensure that 10-year U.S. Treasury yields remained below 2% for the majority of the past 18 months.
Other central banks have clearly recognised the effectiveness of forward guidance and picked up on the trend. Indeed, in an effort to push down government bond yields, on July 4th (Independence Day in the United States) the ECB and the Bank of England jumped most of the way onto the bandwagon. The ECB, finally deeming the economy sufficiently weak, departed from its sacred “no pre-commitment policy” by announcing that the “Governing Council expects the key ECB interest rates to remain at present or lower levels for an extended period of time.” The Bank of England issued a statement to say that the “expected future path of Bank Rate was not warranted by the recent developments in the domestic economy,” and also stated that forward guidance would be discussed in the August meeting.
Why does central bank forward guidance have such a significant impact? A lot of economics depends on the market’s expectation on the future path of policy rates. Essentially, forward guidance is increased transparency about the central bank’s thoughts on where they want to take that policy rate – markets don’t have to read through code words and metaphors to understand what the bank wants to do. Increased transparency improves financial and economic performance by reducing uncertainty and by encouraging financial markets to anticipate policy actions, thereby reinforcing those actions. A.k.a., a virtuous circle. Renowned economist Michael Woodford has argued that monetary policy will have a bigger effect on longer-term rates the longer the central bank credibly commits to maintaining its policy rate. (If you want to see how prescient Woodford is, check out this article he penned back at the beginning of 2008, where he specifically examines how the Fed could begin incorporating forward guidance.)
In fact, perhaps rather than jumping on the bandwagon, the ECB and the Bank of England were attempting to introduce their own Independence Day, since their decisions to introduce (or discuss) forward guidance were also aimed at weakening the correlation between domestic yields and U.S. Treasury yields.
After all, the Federal Reserve has managed to push Treasury yields sharply higher in the past two weeks as it upgraded its assessment of the economy and altered forward guidance on policy rates. Now that the policy signal is moving in the opposite direction, the market is trying to digest the fact that forward guidance can also signal reduced U.S. policy support. Unfortunately for Europe, the economy on their side of the Atlantic is not as strong as that in the States – so ECB President Draghi has had to dig deep into his pockets to find a way to break the correlation and ensure that the more hawkish Fedspeak doesn’t drag European rates up with U.S. rates.
Will the ECB be successful? Unfortunately, their new communication probably doesn’t go far enough. (Less than a year after “I Want to Hold Your Hand,” the Beatles were singing “I Should Have Known Better.”) Its forward guidance isn’t as aggressive as what we’ve seen from the Fed over the past two years. If the market believes that the ECB is only beginning its foray into forward guidance, it may give the central bank the benefit of the doubt and put downward pressure on yields. But until this happens, and as long as U.S. economic data continues to surprise to the upside (see June U.S. payroll numbers), the ECB will have a task on its hands.
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