After the Federal Reserve, the Bank of England has changed its communication on monetary policy.
As the economy was in stagnation or on a low growth path, central banks had no trouble to convince investors that it would maintain its very accommodative monetary policy for a long time. It made sense and it was also a reduction of uncertainty as the economic and financial environment was very volatile. Central banks’ credibility was sufficient to convince investors that interest rates would remain low even in the case of improvement in activity.
It is on this point that the situation has changed. Downside risks on the activity were still very high a few months ago but they have receded. Economic activity now gives stronger signs of improvement. It’s stronger than expected. This change was part of Ben Bernanke’s message at his press conference on June 19. Mark Carney the new Governor of the Bank of England gave the same kind of message this morning.
It is therefore necessary to adapt central banks communication. Monetary authorities want to keep interest low even in the case of recovery but they have realized that just saying it was not sufficient. In the short term they don’t want to take the risk of higher interest rates as this could dampen the recovery.
This is why the Fed and the BoE now show how they can and will intervene.
The Fed and the BoE have defined thresholds at which they could start thinking of changing their interest rates. This threshold is defined as a specific level of the unemployment rate. The Fed has set the threshold to 6.5%, the Bank of England to 7%. This scheme supposes that inflation expectations are stable and in the case of the Bank of England that risks to financial stability are limited (In case of higher inflation expectations or of risks on financial stability this threshold commitment would no longer hold)
The goal of central bankers is to maintain interest rates low until growth becomes sufficiently strong and autonomous. This is not currently the case. They want to keep interest low long after the start of the recovery and they signal this commitment by conditioning change in interest rates to these unemployment rate thresholds. To form their expectations, investors will have to take this into account. They hope that they will be able to maintain a relatively low interest rates structure.
In other words central bankers do not want that the current improvement in economic activity feeds expectations of a rapid change in monetary policy and in interest rates as this could disrupt and weaken the recovery process.
Central bankers want to exit smoothly from this long period of very low interest rates and don’t want to create a negative shock on the economy.
The philosophy of the BoE is quite close to the Fed’s message in June: the reduction of the downside risks on economic activity has to be consistent with a smooth exit from the very accommodative monetary policy. It could take 2 or 3 years. (The BoE spoke of 2016)
Given the strategy implemented by the Bank of England, the next issue will focus on the ECB attitude. At the last press conference Mario Draghi did not want to get into the definition of thresholds to better fit the future course of monetary policy. After the sharp change of the Old Lady of Threadneedle Street, the ECB press conference in September will be even more exciting.
More to come