In June, the European Central Bank published a must-read working paper entitled "Communication of monetary policy in unconventional times" (ecb.europa.eu/pub/pdf/scpwps/ecb.wp2080.en.pdf). We highly recommend this 46-page working paper for any serious investor, academic, student, or other person interested in interest rates and central-bank-driven monetary policy.
Eight coauthors and five additional contributors have collaborated to offer readers extensive analysis of central bankers’ forward guidance (FG). They have produced evidence with statistical support and included coverage of major and diverse national central banks, not just the ECB. We believe their findings offer insights for every reader and can be particularly helpful to every central banker, everywhere.
The authors divide central banks’ forward guidance (FG) into two forms: Delphic and Odyssean. Readers know the Delphic Oracle and the epic hero Odysseus from their studies of ancient Greek history and literature, but ECB’s use of these terms in the context of central bank FG merits further explanation below. The authors then measure the results obtained by these two types of FG in terms of market-based pricing references (think interest rates).
They dissect further into time dependency (short-term, medium-term, etc.). For open-ended time, the authors find little value in FG. The Fed may wish to take notice of weakening market dependency on their dot plots.
There is deep work done in the paper on state dependency and the “trade-off between simplicity and accuracy.” For example, the authors discuss the Fed’s simplistic references to the unemployment rate and how that rate proves possibly misleading, such that the Fed may have had to “renege.” The reduction in the unemployment rate has actually resulted mostly from a falling labor participation rate, not from a robustly increasing percentage of the population being employed. Readers are invited to note that Bob Brusca's statistical information indicates that over 90% of the supposed improvement in the unemployment rate is attributable to the decline in labor participation (see: http://robertbrusca.blogspot.com). Were participation held constant since the financial crisis began 10 years ago, the unemployment rate today would be close to 9%, not the present rate near 4.5%.
Let’s return to the authors’ calling upon antiquity to characterize the two key types of forward guidance.
Delphic refers to the pronouncements or predictions of the famous Oracle at Delphi. For some history and an easy discussion of this subject, see coastal.edu/intranet/ashes2art/delphi2/misc-essays/oracle_of_delphi.html. Readers may note how pronouncements about the future, such as those proffered by the Oracle, are merely assertions or opinions, which may have some basis or not. Just as in antiquity, believers who follow opinions do so at their peril. That’s true enough that central bankers would do well to take notice.
In contrast to the Oracle’s prophecies, the epic adventure recounted in Homer’s Odyssey represents an active “commitment” as to time and purpose as the epic hero Odysseus pits his wits and strength against all obstacles to reach his targeted goal: his home on Ithaca, his wife, and his son. The goal remains clear, and Homer’s undaunted hero eventually achieves it. The lesson for central bankers is that markets will respect clarity in the data target (inflation, balance sheet size, employment statistic) if that target is articulated unambiguously. Central bankers, markets want to know where you are going, how you will measure your progress, and what your ETA is.
Buried in the ECB paper is thoughtful analysis of the events that occur when there is disagreement between central bankers and market agents. The authors find that different types of FG result in different market reactions. Any central banker worth her/his salt is invited to study this section and reflect on the positive or negative outcomes of FG in which she/he participated or voted.
We will close with a full quote of the paragraph about “removing monetary accommodation.”
“The ECB has resorted to FG, which has evolved over time, and placed increasing emphasis on its state-contingent nature. Following its meeting on 4 July 2013, the Governing Council of the ECB initially communicated that it ‘expects the key ECB interest rates to remain at present or lower levels for an extended period of time.’ The expectation was based on the overall subdued outlook for inflation extending into the medium term, given the broad-based weakness in the real economy and subdued monetary dynamics prevailing at that time. Following its meeting on 10 March 2016, and complementing the announcement of a comprehensive package of measures, including the expansion of the ECB’s monthly asset purchases, the Governing Council clarified its qualitative FG on future policy rates, stating that it ‘expects the key ECB interest rates to remain at present or lower levels for an extended period of time, and well past the horizon of our net asset purchases.’ Thus, a new interconnected element in the ECB’s FG was introduced linking the future path of policy rates to the ECB’s APP, which, at that time, was ‘intended to run until the end of March 2017, or beyond, if necessary, and in any case until the Governing Council sees a sustained adjustment in the path of inflation consistent with its inflation aim’, i.e. was subject to a mix of time-dependent and state-dependent FG itself. Finally, a third leg of the ECB’s FG has been introduced in December 2015, when it was announced that the principal payments on the securities purchased under the APP will be reinvested as they mature, ‘for as long as necessary’, constituting a case of open-ended FG.”
The eight dedicated professionals and their five additional colleagues who crafted the ECB paper have tackled a critically important subject and delivered valuable assistance to those of us whose role is to guide clients’ portfolios during this extraordinary period of monetary policy evolution.
We applaud the brilliance exhibited in this working paper. We will leave it to serious readers to take the time needed to fully absorb this valuable research. Don’t skip the appendices, as they cover major OECD countries and their respective national central banks.
At this moment we at Cumberland find value in certain bond market sectors (munis) for reasons my colleagues and I have written about. Similarly, we have selected stock markets and sectors using ETFs to capture opportunities.
We are not the Oracle of Delphi. Instead, we strive to be Odyssean, as we would wish central banks to be; and our choices of state dependencies are data-driven and continuously reviewed. Our path (growth or income) resembles Odysseus’s epic adventure in that events may intervene at any time. Thus our portfolio constructions may change.
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