Tuesday, August 21, 2007

'Testosterone' and 'Rampant Testosterone': the ECB's Communication Embarassment

There you have it. The President of the ECB, Jean-Claude Trichet, uttered the 'strong vigilance' mantra in August 2007. For those who don't speak ECB, 'strong vigilance' means: 'we're going to raise rates by 25bps at the next meeting'. Not to be confused with 'vigilance', which means nothing at all, because central banks are always supposed to be vigilant. The language is rugged/masculine: the soldiers of monetary rectitude are on high alert and stand guard over those entrusted to their care: 'testosterone' and 'rampant testosterone' could have been used instead of 'vigilance' and 'strong vigilance' with much the same effect. And then it happened. The world changed - "Events, dear boy, events". A little financial crisis his the Eurozone, the US - indeed in much of the known financial universe. Suddenly it looks as though 25bps in September might not be such a foregone conclusion/done deal.
And of course, Mr. Trichet and others who believe in giving guidance to the markets about the next policy move will point to many statements explaining the difference between giving guidance and preannouncing. "This is not a commitment"; "All options remain open"; "We retain full flexibility to respond to new information".
If that is indeed the case, then why bother with giving the markets your current best guess about the next move. We know that the current interest rate decision (typically -25bps, 0 bps or +25bps ) has no macroeconomic significance in and of itself. Economic activity, including inflation are driven by past current and anticipated future policy rates. The weight of the current rate (to which the authorities are committed for at most one month), independent of what the current rate implies for future rates, is just about zero. What is true for the current policy rate is also true for next month's policy rate. It is of no material macroeconomic significance. Yet financial market participants spend extraordinary amounts of resources trying to figure out the next policy move. That is because vasts amounts of money are bet on the outcome of next month's monetary policy decision. The resolution and settlement of these bets is purely redistributive among market players and therefore of crucial importance to each one of them. In the aggregate it is pretty much a wash as regards its macroeconomic impact.
Yet by dropping massive hints about next month's policy move, the ECB encourages the myopia distorting so many private financial market decisions. Instead of focusing on what matters, the central bank's contingent policy response to news and events in the future, all eyes are on next month's rate move. If central banks feel they must say something about future policy rates, let them say something about future policy rates from now till Kingdom Come. Let them do so either in the form of reaction functions (such as Taylor rules) or through a fan chart. But please, don't encourage the shortening of horizons in private financial markets, where the short run is the next trade, the medium term is lunch and the long term is the end of the trading day, or whenever positions have to be squared.
Best of all, say nothing about future policy rates. Explain the central bank's view about its mandate and objectives and about the monetary transmission mechanism. Given enough history, even that would not be necessary, because the central bank's reaction function would be understood by all market participants who would be aware of the central bank's track record. Ah, how sweet the sound of central bankers saying nothing at all!

© Willem H. Buiter 2007

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