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A world of shifting central bank frameworks is a riskier one for markets

Anticipating policy shifts by central banks has never been easy but recent developments suggest it’s about to get more difficult – with potentially big implications for asset markets. 

For the past couple of decades, central banks have set monetary policy in accordance with either an explicit or implicit target for inflation. The intellectual thrust of inflation targeting was to anchor inflation expectations, make policy more transparent and predictable, and minimise the discretion afforded to central banks. Inflation targeting provided a simple framework for policymakers to communicate their thinking to financial markets, and made it easier for economists and market participants to anticipate changes in interest rates. The theory was that this reduced the costs of bringing down inflation and anchoring it at low rates. 

In hindsight, of course, this narrow focus on inflation led to monetary policy being kept excessively loose, which in turn helped create the conditions for housing bubbles to inflate, leading to the 2008 global financial crisis. The subsequent need to repair private sector balance sheets has meant that deflation rather than inflation has posed the biggest threat for the past decade. 

Central bank policy frameworks are now adapting to the experience of the past 20 years. The adoption of inflation targeting in the 1990s was the logical response to the defining problem of the 1970s and early 1980s, which was high inflation. However, within the space of just over a decade we have lived through two once-in-a-lifetime events: the global financial crisis and the COVID-19 pandemic. Both were largely unforeseen and both wrought huge damage on economies. The world is more uncertain than governments and central banks believed in the 1990s and 2000s. The logical response is to introduce more flexibility and discretion to policy frameworks. This is manifesting itself in different ways. 

No self-respecting central bank governor would ever admit to going “soft” on inflation. But many central banks are becoming more tolerant of inflation overshoots. In the case of the Fed, this has been formalised in the shift to a Flexible Average Inflation Target (or FAIT). The ECB has not gone as far as the Fed but, as our Chief Europe Economist Andrew Kenningham has noted, the changes to its policy framework that were announced last week mark the end of the “Bundesbank tradition”.  

At the same time, central bank remits are expanding or being interpreted differently. The implications for policy are not immediately obvious. In New Zealand, the Reserve Bank now has to take into account the effect of its policies on house prices. Given that the housing market is displaying signs of overheating this could push the RBNZ to tighten policy earlier than would otherwise be the case. Meanwhile, the Fed is putting more weight on the full employment side of its dual mandate and interpreting it in a manner that would cause policy to be kept looser than would otherwise be the case. Other central banks, including the Bank of England and Bank of Canada, have included labour market outcomes within their forward guidance. 

One consequence of central banks having more discretion over policy is that it will become more difficult for them to communicate how, when and under what conditions they intend to make adjustments. This is starting to become clear with the Fed’s FAIT framework, which seems to mean different things to different people, including members of the FOMC. 

What’s more, the communication challenge doesn’t just relate to the overall direction of policy: it also relates to the tools that central banks use. In the old days, it was simply a matter of central banks increasing or lowering interest rates. Today they are deploying multiple tools at the same time, including asset purchases, interest rates and macro-prudential measures such as counter-cyclical capital ratios for banks. 

Introducing greater flexibility to policy frameworks is the logical response to the events of the past decade and the self-evident conclusion that the world is more uncertain than governments and central banks had believed. But it increases the risk of policy shocks, either because central banks fail to communicate their intentions to markets or markets misinterpret the signals from central banks.

That’s a dangerous development in a world where high asset prices are increasingly being underpinned by the expectation of continued ultra-low real interest rates. 

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