The highly influential tribe of central bankers gathered in Sintra, Portugal, last week at the invitation of Christine Lagarde, president of the European Central Bank (ECB) for the annual ECB Forum on Central Banking. Some of them — Lagarde; Andrew Bailey of the Bank of England (BOE); Cliff Macklem of the Bank of Canada; and Kevin Warsh, only four weeks into his tenure as chair of the US Federal Reserve — agreed to take part in an unrehearsed panel discussion expertly led by Sarah Eisen of CNBC.
The mantra strongly shared and proclaimed by the panellists was no forward guidance. That is, no insights at all were offered on how the central bankers saw their economies evolving over the next 12 months and more. And all attempts to extract such information about the expected direction of interest rates or the size of their balance sheets were firmly rejected, with Warsh leading the resistance.
That was predictable, given his already widely shared objections to the public prognostications of his Fed colleagues. Though he did make the obvious acknowledgement that monetary policy works with “long and variable lags”, for which some reliable sense of where the economy might be heading would surely be required when setting interest rates today to work their magic tomorrow. Still, if the central bankers had such forecasts, they were determined not to have to share them.
In fact, the ECB and the BOE have refused to offer forward guidance for fear that in an unruly world their forecasts might prove embarrassingly wide of the mark and might have to be defended despite their errors. Lagarde spoke of the necessity for “framework” guidance; that is, to inform the financial markets of the process of reasoning that informs the ECB. That fosters a better understanding of the “reaction function” of the central bank, upon which market participants would draw when predicting the direction of interest rates — something they will continue to do when central banks decide to move their key interest rates higher or lower, as they are bound to do.
But Warsh’s resistance to forward guidance — sharing his forecasts — isn’t based on the chances that the forecast might prove inaccurate. His objection is one of deeper principle: he believes the central bank shouldn’t look forward but only observe as accurately as it can the actual current state of the economy, to which it reacts with changes in short-term interest rates. And that is what he regards as the most important instrument of monetary policy.
He does not wish the Fed to feed the market with news — to add grist to the hedge fund mill that leads the market and thrives on uncertainty and accompanying volatility. He would rather have the well-informed marketplace feed him better and more timeous information about the current state of the economy, to which he could then react appropriately — removing or spiking up the punch bowl, as we used to say. Thus, he would wish the Fed to become more, not less, data-dependent, but with superior data drawn from the current state of the economy rather than to act on unreliable forecasts.
Which is indeed the actual state of monetary policy. In an essentially unruly world, monetary policy is very largely data-dependent. It reacts to the observed state of the economy as best it can. Though the financial markets will always be driven by expectations of the future, the developments on financial markets — equities and debt — that profoundly influence the real economy through wealth effects will be forecast-dependent. Hopefully, such financial market behaviour will be highly rational also when interpreting the reactions of central banks and not blindly momentum-driven — momentum that can easily reverse.
The panel referred to significant changes in the government debt markets. And seasoned central bankers who survived the global financial crisis are well aware of the risks, the unknowns that might abruptly change the course of financial markets. To which they may be forced to react — having to act outside of their normal lanes — as the phrase goes, in ways that they would prefer not to. But such grave potential dangers that might soon call upon all the skills and resolve of central bankers weren’t top of the panel’s mind.
Top of mind for Warsh was clearly AI and its huge promise for the US and other economies. He is aware that the demand side of the US economy is being greatly stimulated by the extraordinary investments being made in rolling out AI. He refers favourably to these impressive real forces rather than financial engineering that is driving the stock markets. And he is optimistic about the supply of goods and services increasing in response over time. He mentioned now being the most consequential time to be a central banker. I would suggest that having to wait and see these supply-side responses makes higher interest rates in the US less, not more, likely this year.
Warsh hopes his six task forces of the best and brightest will help him do a superior job managing inflation and the labour market, and perhaps point the way to superior sources of data about the economy. And hopefully also point to better ways of managing supply-side shocks and understanding inflationary expectations that are not simple extrapolations of past inflation.
I was struck by one lacuna in the panel discussion. When asked about the key indicators the central bankers watch or ignore, none mentioned the money supply or financial conditions more generally. Perhaps the task force can explain again in an old-fashioned way why the money supply and bank credit can go a long way in explaining and containing inflation.
• Kantor is head of the research institute at Investec Wealth & Investment. He writes in his personal capacity.
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