Robert Pringle's Viewpoint: Let the Fed lead

Does it matter what the Bank of England, Bank of Japan, the European Central Bank (ECB) or even China's People's Bank of China (PBoC) do about interest rates if it is the Federal Reserve that really sets global monetary conditions?

All have seen action in recent days, but as the Fed is the conductor of the global central banking ‘orchestra', let us start there.

Fed chairman Ben Bernanke, in his semi-annual monetary policy report to Congress this week, left little doubt that the Federal Open Market Committee (FOMC) would keep its foot on the gas pedal. To be sure, it has been preparing markets for a major shift in policy stance – one day. But that's a long way off. In the first of two days of testimony, on July 17, he said that even if unemployment were to fall below 6.5%, a threshold mentioned in previous forward guidance, policy rates would not necessarily be raised. It "would not automatically result in an increase in the federal funds rate target", he said. Few economists expect the jobless rate to reach 6.5% until 2015. Even then, if inflation remained low, the Fed would feel under no compulsion to raise rates in a knee-jerk manner just because such a threshold had been reached.

More generally, Bernanke was keen to dispel the uncertainties that had been generated in markets by his somewhat clumsy attempts to provide forward guidance in previous weeks. His aim was to educate the markets into understanding that the speed and breadth of the inevitable policy change is dependent on incoming data. The Fed is dealing with a moving target – and has taken risks with its balance sheet to a degree that not even other leading central banks have done, notably in underwriting the US mortgage market. Mortgage rates continue at around 2.5% only courtesy of the Federal Reserve.

The chairman also preserved the Fed's room to manoeuvre on asset purchases also, saying: "Because our asset purchases depend on economic and financial developments, they are by no means on a pre-set course."

Should markets worry that ‘splits' in the ranks of the Fed's policy-makers might force a change of course? No. With the support of William Dudley, head of the New York Fed, and Janet Yellen, vice- chairman, Bernanke is assured of control of the FOMC.

Much excitement has been generated by Mark Carney's debut as governor of the Bank of England, and he got the impact he wanted by delivering a ‘unanimous' vote in the Bank's normally fractious monetary policy committee at the first meeting he chaired on July 4. The volume of asset purchases will be held unchanged at £375 billion and Bank rate at 0.5%. On August 7 he will present the results of the Bank study, undertaken at the request of Chancellor of the Exchequer George Osborne, on the merits of thresholds for forward guidance on interest rates. The betting is that he will opt for a qualified unemployment intermediate ‘threshold' – following in Bernanke's footsteps, a few respectful paces behind.

Like his colleagues at the Fed and the Bank, Mario Draghi at the ECB has also been struggling to find ways of supporting recovery, as the euro area recession continues. Its effort to do this by saying (in a unanimous statement) that rates would be held low for an "extended period", however, led to confusion when members of the rate-setting body offered their own "gloss" on this guidance. Similarly, the impact of Haruhiko Kuroda's dramatic debut as governor of the Bank of Japan in April has been blunted by deepening doubts about whether the target of 2% inflation in two years is feasible and by fears for the solvency of Japanese banks when yields rise. Two of the nine members of its Monetary Policy Committee rebelled, and bond yields have become volatile. Meanwhile, towards the end of June, in Beijing, the veteran governor Zhou Xiaochuan, head of the PBoC, deliberately gave banks a little jolt when the central bank delayed relieving a period of extreme monetary tightness as quickly as markets had expected – the so called Shibor shock.

Central bankers are well aware that their policies of extreme ease carry serious risks. They detach asset valuations from real factors. Nobody knows to what extent asset prices will fall when normal rates are restored – or which asset classes will suffer most. CPI inflation can remain subdued while asset prices soar or spillovers cause global turmoil. Bank profitability and solvency come to depend critically on sustaining low rates. (It is instructive that the US exit from the period of ultra-low rates after World War II was accompanied by special measures to ease the effect on financial institutions. But few states are in a position to offer such transition support now.)

Prolonged periods of ultra-low rates "tend to encourage aggressive risk taking, the build-up of financial imbalances and distortions in financial market pricing", according to the Bank for International Settlements annual report this year.

The most serious drawback of all is that current central bank policies reduce the pressure on governments to reform public finances and financial sectors.

Forward guidance sows confusion
There are further problems with efforts to provide forward guidance on the future path of interest rates. What new information can policy-makers credibly provide markets that the markets cannot deduce from the interest rate decision itself? How can forecasts of future actions be credible, when policy-makers know no more than markets about the conditions they will face 12 months or more from now? The markets will never be satisfied with the amount and quality of guidance being offered, which can never provide for all possible future states of the world. They will always press for more, and in the process of providing it, policy-makers will always court further confusion. Already central bankers seem to be running scared of markets. And most ominously of all, promises incorporating thresholds for lower unemployment or higher output raise unjustified expectations that central banks can deliver such aims in the longer term.

Market participants report that financial conditions are more fragile than perhaps at any time since 2008–09. Banking remains on life support. The world economy remains trapped in the cycle of ultra-low interest rates leading to short-term economic recovery, asset price booms and over-extended financial systems and households, followed by a slump and an extended period of balance sheet repair. Market participants know that the process of repair after the last bust has a long way to go.

Against this background, in a more rational world, the major central banks would be coordinating policies to reduce the risk of another global meltdown in what is likely to be a dangerous and prolonged period of transition. Sadly, such coordination is unlikely. Governments remain wedded to insular approaches as these give them access to easy financing.

However, the cloud has a silver lining. With the US dollar even more dominant, all other central banks have to take their cue from the Fed. Explicit coordination can be ruled out; the reality of Fed dominance ensures a form of implicit coordination. And that is certainly better than nothing. In that sense, the answer to the question I posed at the outset is: "only to a limited extent".