The big central banks need to use their time outs wisely

The writer is president of Queens’ College, Cambridge, and an adviser to Allianz and Gramercy

All four systemically important central banks — the Bank of England, Bank of Japan, European Central Bank and the Federal Reserve — effectively called a “time out” on major policy actions in the last two weeks. In three of the four cases, it was the right thing to do provided the time out is used to good effect.

All four central banks coupled a decision to maintain unchanged interest rates with an open door to the possible resumption of increases down the line. One of them, the Bank of Japan, also adopted a small tweak to its “yield curve control” policy of buying bonds to keep yields low.

On the surface, all four central banks now have time to assess the impact of their past actions and internalise more data. Yet what they should do goes well beyond this. Specifically, they need to think carefully on what type of time out they believe they have called.

For many of us, a time out is simply a reminder of a punishment we risked as children. For the sports fans among us, however, the concept applies to a much broader range of situations. Indeed, for the purposes of this column, we can think in terms of three types of time outs that are in American football, basketball and elsewhere.

The first is a tactical time out to deal with an injury on the field, buy time to review the call on a previous play, or stop the clock from running out. The second type is more strategic as it seeks to change the game’s momentum and/or provide time to think deeper about future plays. Finally, there is the psychological time out aimed at disrupting the opposition by “getting into their heads” (ie as seen in American football).

There is an understandable temptation for all four central banks to think that they have called the first type of time out that allows for a pause to reflect on recent developments, clean up small loose ends, and incorporate another round of backward-looking data into their analysis. After all, while the data is largely going their way, the BoE, ECB and Fed feel that they still need to get a good handle on the cumulative effects of their aggressive hikes. The BoJ, for its part, is assessing the impact of having allowed the 10-year government bond yield to move almost a full percentage point under the series of YCC tweaks.

Yet such a tactical framing would be too narrow and, in the longer term, problematic. There are strategic issues that require more timely responses.

All four need to supplement their often-repeated “data dependency” with a clearer, forward looking characterisation of the economic context and, with that, what now constitutes the equilibrium interest rate for the economy of tomorrow — the level consistent with sustainable economic growth and stable inflation.

They also need to improve forecasting techniques and be clearer about the trade-offs involved in achieving the banks’ inflation targets. Lastly, and most controversially, the targets themselves may need review with an open mindset.

The Fed’s need for a strategic time out is amplified by four required course corrections: address repeated communication mishaps, revamp an outdated Monetary Policy Framework, restore credibility, and enhance accountability.

The Bank of Japan needs to think of its time out in the most holistic fashion, especially as markets lose patience with what is viewed as an overly cautious exit from YCC. The recent policy announcement fuelled both higher yields and a weaker yen — a combination that again forced the central bank to purchase bonds and threaten a currency intervention as well.

Rather than stop the clock, this time out may have inadvertently accelerated its run off at a time when the BoJ is lagging markets in exiting from an overly-protracted regime of direct yield repression. That regime has distorted the financial system, risks being economically counter-productive, and is now more exposed to a disorderly dismantling.

For two years, the world’s leading central banks wrongly called a time out on inflation that proved harmful to economic and financial wellbeing, hitting particularly hard the most vulnerable segment of their citizens.

The frantic catch-up process that followed has now allowed three of them to call another time out, this time on policy hikes and from a stronger position. Let us hope that, by thinking of this in strategic as well as tactical terms, they will strengthen their policy prospects and, in the process, enhance their defences against the rising risk of adverse spillovers from a messy exit from the YCC programme in Japan and the upcoming avalanche of government debt issuance in several countries.

Letter in response to this article:
Bank of Japan should be targeting positive rates / From Kiminori Yamaguchi, Tokyo, Japan