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Why coherent communication matters to central banks

Why coherent communication matters to central banks Anthony Harrington

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A recent study, Confidence Erosion and Herding Behaviour in Bond Markets, by two Bank of Japan specialists investigated the way in which analysts and the media react to Bank of Japan (BoJ) statements about changes in long term interest rates. The study throws up a number of interesting points.

As the paper's authors Koichiro Kamada and Ko Miura note:

"When participants in bond markets lose confidence in their outlook for future interest rates, their investment decision depends heavily on the development of market prices. This often leads to herding behavior among traders and destabilizes market prices: demand fuels further demand, or supply fuels further supply."

This leads to a sharp increase in volatility in bond prices. What the authors found, they say, was that the key to understanding the developments in long-term interest rates through a particularly volatile period in 2013, lies in how traders interpret information flows in the market, with the most important of these information flows being policy announcements from the BoJ. The effect of these information flows on weakening or strengthening trader confidence is tightly coupled to bond price movements, they argue.

For the authors, their analysis highlights the importance of formulating a communications strategy as part of the conduct of monetary policy. But it also throws into sharp relief the challenges in implementing what the Federal Reserve and the Bank of England call "forward guidance".

In an era of zero bound interest rates (negative in the case of the European Central Bank), forward guidance such as statements about "loose for longer" and "no interest rate rises for two years at least" becomes a key instrument for monetary policy. However, the flip side of this coin is that if a policy is new, which was the case with the BoJ’s policy after 4 April 2013, when QE came into effect, traders may well feel that outcomes are uncertain and they know that if the facts change, the central bank will change its views, so what it says today is not necessarily clear guidance for tomorrow.

In fact, outside the remit of Kamada and Miura’s paper, the world was given a clear instance of this when the relatively new governor of the Bank of England, Mark Carney famously retracted a warning that interest rates could soon rise.

Carney put the central bank dilemma in a nutshell: "When the facts change, I change my mind," he told the Treasury Select Committee, which, of course, is what you are supposed to do, if you don’t want to steer the economy into a wall. But when you come right out and say this as a central banker, then you give "forward guidance", you shouldn’t be surprised if the markets shrug and say, "Make of that what you will..."

Of course, Carney’s case was rather different from the BoJ’s case. The BoJ was, and still is, trying to boot the Japanese economy towards meaningful inflation, and finding it heavy going. Carney, on the other hand, wanted markets to understand that he intends to ensure that market rate expectations henceforth pay more attention to volatility in the data, instead of resting quietly on the strength of "loose for longer" forward guidance. His intention was to signal that as we exit from "extraordinary policy measures" towards more normal rates, markets should expect things to get a lot more bumpy. Clear forward guidance, after all, can only be clear for as far ahead as any central bank can see, and if it has to swerve to avoid the rocks, it expects market participants to swerve with it, not to complain about inconsistencies in the message.

What Kamada and Miura’s paper points out is that, while it is all very well and good for central bank governors to a) try for consistency and b) change when the facts change, the net result on trader behavior will be "herding behavior". To translate this, couple the word "herd" with the word "stampede". Not what central banks want at all! The last thing they want is a sharp increase in volatility as traders amplify small signals into massive stock movements. Which just goes to show that it’s not much fun heading up a central bank. In that respect, Carney seems to have played his cards exactly right. Treat it like a football manager’s job. Make them pay you oodles up front and have a golden handshake written in to the contract if things go pear shaped and they punt you out!

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Tags: Abenomics , Bank of Japan , BoJ , central banks , forward guidance , Mark Carney
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