Why central bankers can’t follow the markets
Inflation targeting by central banks across the world rests primarily on two key pillars: accountability and transparency. Given the importance of central bank communication in bringing about transparency, an important question that arises is: How much attention should central bankers pay to financial markets?
Before examining this question, I must clarify that independence from the financial markets can never be attained. Nor is it desirable, as monetary policy works via financial markets. Therefore, central bankers must factor in both the expected reaction and the actual reaction of financial markets when formulating their policy. However, should central bankers “follow the markets”, i.e., pursue the policy path that markets have embedded in stock and bond prices?
There have been comments recently that central bank communication may have caused a decline in bond prices. While such commentaries rarely surface when bond prices rise following central bank communication, the key question about the relationship between financial markets and central banking policies remains.
Prudent central bankers would profess that following the markets as defined above would produce poor policy for several reasons. First, as markets react to fundamentals as well as to fear and greed, they can run in herds and overreact or underreact to even the slightest pieces of information, despite signals from the central bank. Central bankers need to be a lot more cautious and prudent.
Second, financial markets are quite susceptible to speculative bubbles that can stray far from fundamentals. However, central bankers must cloister themselves from the whims and fancies of speculative markets and keep an unwavering eye on the fundamentals.
Third, financial market participants—even those that trade in long-term instruments—often behave myopically as they are eyeing only the bonus at the end of the year. In contrast, central bankers can ill afford to be myopic in their decision making.
If the central bank strives hard to please markets, it is likely to mimic the short horizon of market participants and thereby become myopic in its decision making. This can create a dangerous phenomenon of the dog chasing its tail forever, wherein the market reacts, or possibly overreacts, to perceptions about what the central bank might do, and the central bank looks to the market for guidance about what it should do.
Note that no central banker can afford to ignore financial markets as they convey indispensable information about the expected course of future monetary policy and the impact of the bank’s policy changes. However, delivering the policies that markets favour, or even expect, may lead to poor central bank policymaking because it can bring both short-termism and populism into central bank policies; neither of these is desirable.
The broader point is that central banks are provided independence by the country’s legislature—the Reserve Bank of India Act, 1934, in the Indian scenario—because central banking policy, by its very nature, requires a long horizon on the one hand, and the ability to take unpopular decisions on the other. The effects of central bank actions on the macroeconomy manifest after several lags. Therefore, central bankers do not see the results of their actions for quite some time. This facet requires central banks to have a long horizon.
Second, extracting information about economic fundamentals from an inherently noisy economic system involves complexity because the effects of central bank policies show up with considerable lags. Also, fundamentals are rarely revealed directly in the data. As fundamentals must be inferred by weeding out the noise, central bankers can rarely be on the right side of commentators, who cannot be expected to possess the same information set on fundamentals that central bankers do.
In fact, a correct assessment of the success of a central bank policy requires a comparison of what happened vis-à-vis what could have happened, i.e., the “counter-factual” in economist jargon. For instance, if the central bank notices risk patterns that are building up in the economy, a prudent central banker would nip them in the bud, thereby never allowing the risk to manifest.
Commentators who do not have the benefit of comparing with the counter-factual will label the central bank paranoid in responding to risks that never manifested. The irony though is never lost on the central banker, who only treats it as an occupational hazard.
More importantly, maintaining monetary and financial stability involves a cost-benefit trade-off where the costs are incurred upfront while the benefits are seen gradually over time. However, most politicians, the mass media or the public cannot exercise the patience required of central bankers. Anticipating these difficulties, legislators and governments across the world wisely depoliticize central bank policy by putting it in the hands of unelected technocrats who are isolated from the compulsions of politics.
Therefore, when examining how far central bankers should follow financial markets, we should keep in mind this broader point about the need for the central bank to remain immune from short-term pressures and populism.
Krishnamurthy Subramanian is associate professor of finance at the Indian School of Business, Hyderabad.
Comments are welcome at firstname.lastname@example.org