With interest rates unlikely to return to the zero mark, central banks, bond markets, and equity markets are all acknowledging this new reality. However, it’s not just about what central banks communicate; it’s equally about how they deliver their message.
Recent studies, including one by Haroon Mumtaz, Roxane Spitznagel, and their colleagues, have dove into the impact of central bank communications on asset prices, revealing the nuanced power of words in monetary policy.
The Power of Communication in Monetary Policy
The study’s findings underscore that the manner in which information about future policy paths is conveyed significantly affects asset prices.
For instance, speeches by Monetary Policy Committee members have a more substantial influence on medium to long-term gilt yields than interest rate announcements and press conferences.
This trend is even more pronounced in the United States, where Federal Reserve chair speeches play a pivotal role in driving stock prices and bond yields, overshadowing Federal Open Market Committee announcements in their impact.
However, the challenge of effective communication is complex. Often, complexity in communication leads to increased asset price volatility, which is undesirable from a macroeconomic standpoint.
This complexity can stem from various factors, such as a challenging economic environment or internal conflicts within the Monetary Policy Committee.
For example, during economic shocks like the pandemic and the war in Ukraine, central banks faced the daunting task of navigating new concepts and data, making their communication inherently more complex.
Moreover, the Bank of England’s communication has become more intricate over time, reflecting the increasingly challenging environment.
Central Banks and the Future of Interest Rates
The role of central banks extends beyond mere communication; it also involves the cyclical and structural components of interest rates. Central banks set policy rates above the neutral rate, also known as r-star, during periods of high inflation and resilient growth.
Presently, with the Federal Reserve, European Central Bank, and Bank of England declaring that rates are restrictive and will remain so, the focus is on how long high rates will persist.
Research indicates that rates might recede from their cyclical peaks in 2024 as the economy returns to equilibrium. The neutral real rate of interest in the US has risen since the 2007-8 financial crisis, with similar trends observed in the UK and euro area.
This shift suggests that average interest rates in the next decade could be significantly higher than in the past decade, with profound implications for governments, markets, and investors.
Clear and simple communication from central banks can help mitigate volatility and provide financial markets with a medium-term rate anchor.
The Federal Reserve’s dot plots, a projection of longer-run interest rates, have been slow to adapt, reflecting the challenges in estimating the neutral rate. The ECB and Bank of England have also been cautious in providing guidance on neutral policy settings.
Bottomline is clearly, central banks play a critical role in shaping economic stability and growth.
Their ability to effectively communicate policy paths, embrace the neutral rate, and provide clear guidance is crucial for reducing market volatility and ensuring the smooth transmission of monetary policy.
As we navigate through uncertain economic times, the clarity, timeliness, and simplicity of central bank communication will be key to maintaining financial stability and fostering economic resilience.