For somewhat more than a decade I have regularly been watching monetary policy decisions from different central banks around the world. Most ‘modern’ central banks in the world announce changes to monetary policy once every month. Mostly these events are pretty much none-events – the central banks do not surprise markets much. However, over the last fives years it has certainly been harder to predict the outcome of these meetings compared to how relatively easy it was in the decade before the crisis.
The reason it has become harder to predict central banks is that we are no longer on ‘autopilot’ in monetary policy. One we are unsure about ‘where we are going’ – the central banks’ monetary targets have become less clear – and in some case the target has even changed. Second, especially central banks where interest rates have dropped to close to zero are unsure about what instruments to use in the conduct of monetary policy.
This uncertainty has created more volatility in financial markets as the markets have a very hard time “reading” the central banks. The monetary policy decision from the Bank of Japan this morning is instructive.
Yesterday the Nikkei was up around 5%, but this morning the market has been slightly nervous ahead of the monetary policy announcement. However, after the announcement Nikkei initially dropped 1.5% on ‘disappointment’ (as it is said in the financial media) that the Bank of Japan did not introduce new measure to curb ‘bond market volatility’.
This is really rather bizarre. Central banks really shouldn’t run around and announce new initiatives and new monetary policy instruments every other month. Unfortunately we look at the major central banks such as the Federal Reserve, the ECB and Bank of England these banks over the past five years again and again have introduced new policy instruments. A lot of these instruments have not even been aimed at changing monetary conditions (changing the money base and/or expectations of future changes to the money base), but have been credit policies.
Ideally central banks should not even need to hold these monthly monetary policy meetings. If the central bank clearly defines its monetary policy target and define what primary instrument it is using to change monetary conditions then monetary policy to a large extent would be on autopilot.
Try to target one target and no more than that
First of all the central banks of the world should make it complete clear what they are trying to achieve. What is the central bank targeting?
Second, the central banks should make it clear that it is targeting future value rather than present value of these variables – be it inflation, the price level or nominal GDP. Therefore, central banks should communicate about the expectation for these targets.
For inflation targeting central banks like the Bank of Japan the central bank is lucky has it actually have market expectations for future inflation. Hence, there is no reason for the Bank of Japan to even comment on present inflation. The only thing, which is important, is market expectations. If market expectations for future Japanese inflation is below the BoJ’s 2% inflation target then the BoJ will have to conclude that monetary conditions still are too tight. It can of course easily do something about that – it can just announce that it will continue to escalate the growth of the money base until the market is pricing in 2% future inflation. Remember there are no limits to the central bank’s ability to print money. The term that the central bank should keep the powder dry therefore is also idiotic. The central bank will never run out of gun powder.
Third, central banks should stop confusing themselves and the markets by pursuing more than one target. Essentially the central bank only has one monetary policy instrument – and that is the money base. Hence, the central bank can only hit one nominal target. One would think that this should be obvious, but unfortunately it is not.
Lets take the example of the Polish central bank (NBP). Last week the NBP cut its key policy interest rates by 25bp – effectively trying to boost the growth of the money base. Within days after that decision the same Polish central bank intervened in the currency market to strengthen the zloty. Hence, the NBP was selling foreign currency and buying zloty. Said, in another way the NBP tried to reduce the money base. Are you confused? It seems like the NBP is.
Unfortunately the NBP is not the only central bank in the world, which is confused about its own policies. The recent increased volatility in the Japanese markets is exactly a result of a similar kind of policy maker confusion. In April the BoJ moved decisively to ease monetary policy. This was seen as a credible and permanent expansion of the money base. Not surprisingly this sparked a rally in the Japanese stock market, weakened the yen and have push up nominal bond yields. Market Monetarists were not surprised. Higher bond yields reflect higher growth and inflation expectations.
However, the BoJ seems to have been surprised by the impact of its own actions – particularly the increase in bond yields have made policy makers nervous. This led both BoJ and government officials to make unclear statements about the connection between bond yields and monetary policy. However, it is clear that if the BoJ in somewhat tries to target the level of bond yields it cannot also target inflation.
A similar problematic tendency of central bankers these days is an aversion against using certain policy instruments. Hence, central bankers have a preference to conduct monetary policy through interest rate changes. However, if the interest rate is close to zero then other instruments have to be used – for example directly expanding the money base.
However, it is very clear that for example a lot of Federal Reserve officials can’t wait to reduce the US money base. Logically that obviously makes no sense as it basically mean that the policy instrument enters on both the left-hand and the right-hand side of the central bank’s reaction function. The fed should obviously not reduce the money base before it is clear that it will hit its – not too well-defined – target.
The textbook advice to central banks therefore must be to target one nominal variable and target the market expectation of the future value of this variable.
Let the markets be the autopilot for monetary policy
If the central bank formulates its target in the form of expectations then it is really very simple to introduce an autopilot monetary policy.
Again lets take the example of the Bank of Japan. The BoJ is now officially targeting inflation at 2%. It wants to achieve that target in two-years.
The market obviously provides a measure of how likely the BoJ is to meet this target in the form of breakeven inflation expectations from inflation-linked Japanese government bonds. The verdict from the market is clear – while inflation expectations have risen significantly the market is still far from pricing in 2% inflation.
In fact 2-year/2-year inflation expectations – that is the market expectations for inflation two years from now and two years ahead – is closer to 1% than to 2%.
So while the BoJ has credibly eased monetary policy its inflation target is still far from credible.
The easiest way to make that target credible is simply to announce that market expectations for Japanese inflation should be 2%. Or as I have suggested before the BoJ should simply ‘peg’ the inflation expectation to 2%. It should announce that if inflation expectations are below 2% when the BoJ will simply buy inflation linked bonds until inflation expectations hit 2% and similarly of course sell inflation-linked bonds if inflation expectations move above 2%.
In that scenario Japanese monetary policy would be completely on autopilot. The BoJ would not have to confuse itself and markets by introducing instruments every months or by giving cryptic statements about the state of the Japanese economy.
The BoJ could simply monthly report on the markets’ inflation expectations. If that BoJ did that then this months’ monetary policy statement would look something like this:
“The Bank of Japan is targeting 2% inflation. Market expectations for inflation on all relevant time horizons shows that inflation expectations have increased over the past year. Unfortunately inflation expectations are still significantly below 2% and as such the 2% inflation target is no yet fully credible.
However, the Bank of Japan has the full control of the Japanese monetary base and is ready to expand the money base as much as needed to bring inflation expectations fully in line with the inflation target. Hence, the Bank of Japan will continue to step up the buying of inflation-linked government bonds until there is full correspondence between the inflation target and market expectations.”
If I were a market participant that read that statement I would start buying inflation-linked bond immediately – and I would sell the yen and buy some more Japanese equities. And I am sure we very fast would see the market price in 2% inflation. Mission accomplished.
And once inflation expectations have been ‘pegged’ to 2% the BoJ could simply put the following text on it website: “Bank of Japan targets 2% inflation. Inflation expectations are at 2%. Monetary policy is 100% credible. We have gone golfing”.
I am writing this on a flight to Brussels (so I am not on the internet) while BoJ governor Kuroda is having a press conference. I very much hope he will be saying something similar to what I have suggested, but I am not overly optimistic.
Update: A quick glance through Kuroda’s comments indicates that he doesn’t really get it. He talks about controlling bond market volatility and makes some but not too impressive comments on breakeven inflation rates. It is sending stock markets down around the world. (By the way if Japanese monetary easing is part of an evil ‘currency war’ why are global stock markets falling when the BoJ fails to deliver?)