Russell Silberston | Central banks: It’s good to talk
‘It’s good to talk’ was an award-winning 1990s advertising campaign for BT, fronted by the wonderful and much-missed British actor Bob Hoskins, in which Bob tried to convince Britain’s taciturn men to spend more time on the telephone. Central banks also discovered the delights of more communication around the same time, believing that speeches, press conferences and interviews were valuable tools that helped to anchor the public’s inflation expectations and the market’s view of future policy.
Such guidance has been invaluable in the recent and historically fast interest rate cycle, enabling the public to understand by how much interest rates are likely to rise and more importantly why this is necessary. Equally, guidance has tightened financial market conditions quickly, transmitting monetary policy through to equity and bond markets and so on to the wider economy.
The US Federal Reserve (Fed) has been an exemplar of this strategy, being upfront with the public about the costs of its action and explaining how, while it understands that these actions affect communities, families, and businesses; restoring price stability is essential for achieving long-term maximum employment. With respect to financial markets, the Fed told us clearly that policy initially needed to get to a more neutral setting (from super loose) and then to restrictive levels. Once the Fed reaches the latter point, it will be necessary to keep rates there until it is confident that inflation will return to target. Bob would have admired the Chair’s straightforward language.
However, one dreads to think what he would have said about the Bank of England’s communication efforts. In its recent press conference on the 9th of August, a simple word count of the transcript records that economic models were mentioned 22 times. The same exercise for the Fed records no use of the word model in the past three press conferences.
This modest exercise reveals the source of the Bank’s current problems, namely an over-reliance on economic models for policy making that are just not fit for purpose in the post-Covid economic environment. Setting interest rates based on a modelled output of medium-term economic growth and inflation is difficult in benign times. Over the past three years it has been impossible.
The Bank, however, has belatedly recognised this problem, but rather than develop a new strategy to deal with the huge uncertainties that have shaken the global economy in recent years, it uses discretion to tweak its modal, or most likely, forecast to try and account for the opaque future. The Bank’s defence is, to quote from the August press conference, ‘there are always judgements. The forecasts are rightly described as the best collective judgement of the committee. The models are a guide.’ Perhaps then the judgement has been incorrect?
The Old Lady’s problems are compounded by an absolute refusal to discuss where it thinks neutral interest rates are. Simply put, this is the level of interest rates that are consistent with growth at trend and inflation at target. Anything above this level should slow growth, anything below stimulates. The Bank’s counter is that neutral, or r-star is a largely theoretical concept and can only be validated ex-post and as such trying to define it precisely can be misleading.
However, for financial markets, r-star is a key input into pricing of long-term interest rates and provides an anchor for mortgages and corporate loans. Without this anchor, longer-dated interest rates become unmoored and so more volatile. This effect can be seen clearly in the UK mortgage market, which is priced off UK interest rate swaps. At their peak in early July 2-year swaps were 123 basis points above Bank Rate. The equivalent in the US at the time was 22 basis points under Fed Funds and in the Eurozone, 44bps above official rates. At the end of the first week of August, they remained 34 basis points above the recently hiked Bank Rate versus -63 bps and -2 bps in the US and Eurozone respectively. In the medium term, there is a 94bps range in the Bank’s own survey of where market participants expect Bank Rate to settle. In the US, the equivalent range is just 13bps. This unmooring of expectations, stemming from a lack of conversation about neutral, has real world consequences in the form of higher borrowing costs.
If the Bank is struggling with modelling the economy and refuses to counter an anchoring of markets around neutral interest rates, then it should be guiding the public, markets and business with clear and concise communication. Unfortunately, it appears to fall here too. Using AI, (ChatGPT), it is possible to assess the complexity of the Bank’s Monetary Policy Summary, the concise 800-word publication used to inform the world about the Bank’s latest world view. This document is assessed as ‘intermediate’ and ‘contains a mixture of complex and straightforward sentences, technical terms related to monetary policy, and economic indicators.’ Compare this to the Fed’s own statement, which is assessed as ‘intermediate, relatively low’ consisting of ‘short, straightforward sentences with simple language and uses common financial and economic terms.’
There can be little doubt that the Bank’s rate-setting process has been sub-optimal. And attempting to defend it by saying we have seen unprecedented shocks doesn’t stack up when the whole world has experienced the same. So, what happens now? To an extent, matters have been taken out of the Monetary Policy Committee’s hands and their own governing body, the Court, has helicoptered in Ben Bernanke, ex-Fed Chair, to undertake ‘a broad review into the Bank’s forecasting and related processes during times of significant uncertainty.’
Looking forward, expect the Bank to move toward the Fed’s model of clear and simple communication, with less emphasis on models and more on anchoring market expectations. Perhaps they could save Bernanke’s fee and just watch those old adverts with the excellent Bob Hoskins. When it comes to monetary policy, It’s Good to Talk.
*Russell Silberston is an Investment Strategist at Ninety One.