Monetary Policy and Financial Markets Two Hands Clapping - PDF

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					Monetary Policy and Financial Markets:
Two Hands Clapping

Remarks by Robert V. DiClemente, Managing Director and Head of U.S. Economic
and Market Analysis for Citibank/SalomonSmithBarney.

Good afternoon. It is a rare privilege for me to have the opportunity to address such
a distinguished audience on the subject of monetary policy and financial markets. If
my remarks echo some of the sentiments expressed by earlier speakers, I hope that
is an encouraging sign that a consensus has emerged on today’s theme across
markets and official institutions.
As a market practitioner, let me state at the outset that I believe the degree of
communication between central banks and the public is good, probably has never
been better, and yet could improve still further. Certainly, in the Federal Reserve’s
case, the improvements have been remarkable. During the past decade, we have
witnessed the abandonment of open market operations as a signaling tool in favor of
explicit and, generally, well anticipated statements of policy changes. While the role
of the Fed watcher divining reserve supply and demand has gone the way of the
telephone operator and the lamplighter, the system now is eminently fairer and more
efficient for the broad public

Communication and Credibility
Regular communication from the central bank is important in at least two respects:
First, it provides a mechanism for accountability for the central bank, a key element
in preserving the Bank’s independence. And second, it provides a means to achieve
credibility in the pursuit of goals laid out by the legislature. Credibility, in turn,
provides some assurance that the markets will be allies in the policy process. The
Fed has only its control of the funds rate. Its success depends on how well changes
in the funds rate are transmitted across the term structure of interest rates and --
equally important -- through a variety of other financial channels affecting liquidity,
balance sheets, the cost of capital and foreign exchange rates.

For some time, there has been widespread consensus that central bank independence
is key to the success of monetary policy, provided independence is directed at
achieving the right goals. By independence, we mean the freedom to form a strategy
in pursuit of the policy objectives set by elected representatives. In this context,
regular communication is a way for the central bank to explain its actions and gain
the confidence of markets and the general public.

I can think of numerous instances in recent decades, but especially in the Greenspan
era, in which the Chairman and other officials have gone to great lengths to
elaborate the rationale for policy changes, sometimes even before the fact, and

    January 14, 2000   Comments on Credit

                       especially at turning points in the direction of interest rates. For example, in
                       testimony by the Chairman, the dramatic turn in policy in February 1994 was
                       explained and defended repeatedly from the summer of 1993 until the very week
                       that the first tightening occurred six months later. And, while many market
                       participants at the time expressed confusion, even anger, over the Fed’s action, the
                       highly public way in which officials articulated the logic of policy -- the importance
                       of removing unneeded stimulus, restoring neutrality, and focusing on forward-
                       looking risks to economic stability -- served the interest of preserving independence.

                       Generally, markets have had good success in understanding policy. And I would add
                       that the Fed in turn has had good success in understanding markets. The information
                       flows in both directions. I will explain why that is important in a moment. If the
                       market is successful, it may be in some rare occasions that the Chairman has given
                       very clear guidance. But in these and other instances, the success is more a function
                       of the consistency of policy decisions, and the transparent way that data and events
                       can be linked to key decisions.
                       Effective communications and the costs of poor communications are difficult to
                       measure in part because policy is capable of achieving its goals with it or without it.
                       We can perhaps appreciate the value of good communications here in the U.S. by
                       observing a recent experience in the Euro area, with events leading up to the latest
                       rate cut by the European Central Bank (ECB). Although officials there have very
                       consciously supported the value of articulating the rationale for policy,
                       developments since March have confused market participants and – only time will
                       tell – could hurt policy’s effectiveness.
                       We can see this breakdown by tracing the path of the implied interest rate on the
                       September three-month Euribor futures contract from late March up to the early
                       May decision to cut. When the first comments surfaced in late March hinting at a
                       rate cut, futures were yielding about 4.15%. They quickly rallied to around 3.95%,
                       where they remained until the next policy meeting, at which time the ECB decided
                       to leave rates alone. Moreover, then and over subsequent weeks, we heard official
                       commentary outlining why expectations of an imminent rate cut might be futile.
                       And futures promptly set back to about 4.60% -- higher than before easing talk had
                       begun, higher than any time this year (see Figure 1). In the face of a deteriorating
                       outlook, central bankers essentially had engineered a modest tightening. Finally, as
                       the outlook weakened further, rates retreated once again, with officials eventually
                       cutting rates.
                       I am sure the damage done to the immediate outlook is trivial. But it would be hard
                       to claim that markets understand ECB policy, even though its mandate is laid out
                       very explicitly. Even though the participants themselves are long-time policy
                       veterans. Only time will tell whether the uncertainty lingers as a tax on financial
                       markets. But as market forecasters, my colleagues and I are likely to rely less on
                       ECB rhetoric as a guide to the policy outlook, and more on data and models, as
                       inadequate as they are.

Figure 1. Implied Interest Rate in Sep-01 Three-Month Euribor Futures (Percent), Jan
01-10 May 01
      .7 %
    4 4 .7                                                                                                    4 .7 %
 4 .7 %
      4 .6                                                                                                    4 .6

     4 .5                                                 First com m ents hinting                            4 .5
                                                                 at a rate cut
     4 .4                                                                                                     4 .4

     4 .3                                                                                                     4 .3

     4 .2                                                                                                     4 .2

     4 .1                                                                                                     4 .1

     4 .0                                                                                          Rate cut   4 .0

     3 .9                                                                                                     3 .9
                                                            April' s press conference
     3 .8                                                suggesting no near- term rate cut                    3 .8

     3 .7                                                                                                     3 .7
        1       0     9       0       8       9       8      9       0       9      9       8       7     8
     n0      n 1 an 1      n3      b0      b1      b2     r0      r2      r2      r0     r1      r 2 ay 0
   Ja     Ja      J     Ja      Fe      Fe      Fe      Ma     Ma      Ma      Ap     Ap      Ap      M

Sources: Eurostat and Federal Reserve Board.

The contrast to U.S. experience could not be sharper, but it was not always so. As
you know, the Fed’s principal challenge over the past two decades has been to
squeeze out inflation and inflation expectations. In 1980, when Paul Volcker was
leading the effort to uproot a deeply ingrained inflation pessimism, he could have
talked to markets every day, all day about all the right things and it would not have
mattered. Like it or not, good policy or not, policymakers had zero credibility with
respect to containing inflation. So in that instance it was critical to make the strategy
of policy transparent.
Relatively rigorous money targeting from late-1979 to late-1982 provided the tool
for transparency that helped wring out inflation. In carrying out that task, the Fed
often found itself at odds with markets. Because long-term inflation expectations
were as high as 8½% by one survey, objective measures of policy had to be
especially tight. Markets in that situation were a headwind of sorts due to the lack of
credibility, and Chairman Volcker deserves special credit, not merely for going
against the market, but on occasion without a strong consensus among the FOMC.
Now, move the calendar forward to1998 against the backdrop of all the success in
the interim, including the handling of the so-called return to neutrality in 1994 that
brought about the soft landing of 1995. Inflation expectations in this later setting are
below 3%. In the midst of massively loose financial conditions, which obviously
firmed rather abruptly with the collapse of the corporate bond market and global
equities, the Fed was able to ease policy rather boldly nonetheless without
triggering widespread inflation fears. Such a policy would have been very difficult
to engineer at another time. By communicating the logic of disinflation policy, by
establishing credible means to achieving it in those interim cycles, the Fed had
bought itself enormous flexibility, and in doing so, made an ally of financial
markets and the general public.

    January 14, 2000   Comments on Credit

                       The Fed as Referee
                       Ideally, it would be nice if the Fed could lay out a model of inflation and how data
                       and economic events feed into the outlook. To be sure, for much of the anti-inflation
                       era, we believed such a model existed. For monetarists, money stock data provided
                       the vehicle. For others, the output gap or the Phillips curve framework was the most
                       useful mechanism. And indeed, when the Taylor rule emerged in the early 1990s,
                       we could see just how consistent the Fed had been. John Taylor had shown that the
                       actual funds rate between 1987 and 1992 had tracked closely the rate prescribed by
                       a rule that guided policy to bring inflation down to 2%, while retaining some
                       sensitivity to short-run economic conditions. When the rule accurately predicted the
                       sharp turn up in rates in 1994 and the subsequent easing off later in 1995 and 1996,
                       it seemed transparency could not have been better. Some even speculated that the
                       Fed was following the rule.
                       Today, however, the issue of communication is doubly challenging, because the
                       Taylor rule too has broken down. In fact, it may be safe to say that the Fed has no
                       reliable concrete model of inflation. Empirical measures of money have been judged
                       unstable. The Phillips curve overpredicted wage gains, let alone unit costs and
                       inflation. And, we don’t know what the output gap is because there is strong belief
                       that potential growth may be in transition based on improving productivity trends.
                       As a result, the Fed wisely introduced the notion of “prompt and forceful” policy
                       change. Hence, while markets and officials alike struggled to sort out the outlook,
                       only compelling proof of a threat to the economy could be the logic for policy
                       In these circumstances, the lines of communication have run as much from the
                       markets to the Fed as the other way around. I am convinced that when the Fed was
                       tightening in 1999 and 2000, officials responded in part to evidence that equilibrium
                       interest rates were being pushed higher with the rise in investment and needs for
                       capital. Minutes of FOMC meetings suggested that rising corporate bond yields
                       were a warning that holding rates artificially too low could have risked greater
                       instability than we are now experiencing on the other side of the cycle.
                       So we should not be too reluctant to agree that some of the Fed’s actions and the
                       market’s success is a function of information flowing from the Street to
                       policymakers. In this sense, the issue of whether or not the Fed is just “following
                       markets” is a false debate. Let me be careful on this point. It is not that officials are
                       simply ratifying market movements. Rather, the market contains information about
                       the outlook independent of policy that is crucial to their decisions.
                       We should not be shocked. After all, our system is largely guided by market
                       mechanisms, and in many respects, the Fed’s role at its best is that of referee rather
                       than playmaker. It is crucial, however, that as a referee, the Fed take into account
                       the tendency in an unregulated world toward financial entrepreneurism, the purpose
                       of which can often be at odds with economic stability. Nonetheless, to the extent
                       that information travels faster and more cheaply than ever, price signals, including
                       open capital market signals, ought to be more effective at buffering the economy,
                       and thereby dampening economic cycles. I believe the record of the past two
                       decades shows that.

As for improvements, my suggestions are limited and secondary to the success of
policy, which as I have argued depends mostly on credible commitment. Judging the
appropriate level of communication will be always be challenging if the Fed is
going to retain the necessary degree of flexibility, especially in a period like the
present, where the uncertainties in the outlook are dominant and the inflation signals
are not well perceived.
I think the Fed should meet more often. At the risk of burdening the staffs, I would
propose one meeting a month instead of eight times a year. And I would schedule
the meetings at comparable points in the data cycle, perhaps with fewer Beige book
reports. Please note, my purpose is not to suggest that the Fed act more often – I
hope not – but to communicate more systematically. At some point as well, the Fed
will have to deal with the awkwardness surrounding their leanings about the future
path of policy. Markets now perceive that the “close monitoring” phrase has
supplanted the former intermeeting bias. And, I think it is fair to say that
abandoning the current tilt in the “balance of risk” statement will have a measurable
announcement effect. If policymakers find themselves in a position where the
immediate policy decision is influenced by the need to communicate it, they will
have to take a closer look at disclosure policy.
On balance, the efforts of the Working Group on disclosure have been well
received. Thanks to good communications, as well as consistency, markets
understand the logic and strategy of policy. Policymakers, in turn, have
demonstrated a clear understanding that the strength of our system of economic
organization lies in part in its self-regulating features, and they have guided the
process well.