Forward guidance and the ‘Greenspan moment’

Over the years, central banks have become more and more transparent in their communication to the point where over the last fifteen years, forward guidance has been introduced as a means to prepare markets for the likely path of monetary policy in the year ahead. This is in sharp contrast to only a couple of decades earlier. Until 1994, the Fed did not communicate its policy decisions until weeks after the fact. Money market traders essentially came into the office one day and realised the Fed was asking for a different interest rate. The very first Fed press conference happened on 27 April 2011 under Ben Bernanke. That was a mere 12 years ago. Yet, today, the press conference and Fed speeches are arguably more important than the actual policy change.

This might have serious implications for the economy overall. Everybody knows that monetary policy by the Fed or any other central banks influences the economy through two channels. First, there is the ‘real economy channel’. Changes in interest rates influence the cost of capital and thus investment behaviour as well as the value of houses and other assets (wealth effect). Furthermore, changes in interest rates influence the exchange rate between currencies and thus can make imported goods more or less expensive.

But there is a second channel. Changes in interest rates influence sentiment and with it the intentions of consumers and businesses to save, consume or invest their money. These sentiment changes kick in well before any changes in interest rates have been made or have been reflected in mortgage rates, etc.

Both channels are important and as a new paper by Ben Bernanke and others explains, we are not really sure how to disentangle the two effects or how big the sentiment effect (or risk-taking channel as Bernanke calls it) is in relation to the real economic effect.

As Ben Bernanke himself once quipped: “The problem with Quantitative Easing is that it works in practice but not in theory”. Quantitative Easing is monetary policy that hardly affects the real economy at all since interest rates remain largely unchanged (long-term bond yields change, but not by much). Yet, it affects the sentiment channel a lot and has arguably created massive asset inflation in the 2010s.

I would argue, and it turns out so would Anil Kashyap and Jeremy Stein, that in a world where central banks communicate more openly and provide guidance for future policy actions, this sentiment channel is becoming more important relative to the real economy channel. And during the period of zero interest rate policies and QE, I would guess that the sentiment channel probably was more important than the real economy channel.

And therein lies a problem because if monetary policy works predominantly through influencing sentiment, it can create a ‘Greenspan moment’.

Readers may be familiar with the ‘Minsky moment’. Hyman Minsky proposed that every period of stability in bank lending and the economy creates the root of a banking crisis. As the economy remains stable, banks tend to loosen lending standards more and more until they are overstretched and eventually collapse when the economy shrinks and too many loans default.

I would like to coin the term ‘Greenspan moment’ in memory of former Fed chair Alan Greenspan’s speech in 1996 where he used the term ‘irrational exuberance’ to describe the dot-com bubble of the late 1990s:

“Clearly, sustained low inflation implies less uncertainty about the future, and lower risk premiums imply higher prices of stocks and other earning assets. We can see that in the inverse relationship exhibited by price/earnings ratios and the rate of inflation in the past. But how do we know when irrational exuberance has unduly escalated asset values, which then become subject to unexpected and prolonged contractions as they have in Japan over the past decade?”

In essence, what he was saying is that low inflation influenced investor sentiment and created an unsustainably high level of risk-taking.

In a way, by keeping monetary policy loose for so long, the Fed and other central banks may have done something similar in the 2010s. they may have created exuberance in financial markets through the sentiment channel by guiding markets to persistently low interest rates and continued QE. And by doing that, they sowed the seeds of the bear market of 2022 when central banks finally reversed the sentiment channel and started to talk tough about inflation.

I am not going to re-litigate why I think fighting a supply shock from higher energy prices with higher interest rates is a fool’s errand and a policy mistake. If you are interested in that, you can read up on it here.

What I am going to say, though, is that now that inflation is coming down, it would be a mistake to spur risk-taking in markets and the economy through half-hearted commitments to fighting inflation. During their February meetings, central bankers tried to convey the message that they will not cut interest rates in 2023 because inflation is expected to remain very high throughout the entire year. But by doing so in a rather half-hearted way, the market didn’t believe them and rallied even stronger.

And this may become a problem later in the year when central bankers have to rein in irrational exuberance by investors, creating another shock to markets. Whether that will happen, I dare not say. But something is increasingly clear. We live in a world where the sentiment channel of monetary policy seems to be dominating the real economy channel.

This should have implications for monetary policy. If the sentiment channel is more important, then central bankers cannot simply rely on their old tools and conduct monetary policy by only looking at the real economy channel. They must make policy with explicit consideration of the sentiment channel and communicate in such a way that investor sentiment is not swinging widely in one direction or another. They must become less like economists and more like ‘market coaches’ that steady the ship in rough waters, boosting confidence when sentiment is low and pulling exuberant markets back. But to do that, one needs top communicators at the helm of a central bank. And unfortunately, I think we have terrible communicators at the helm of the Fed, the BOE and the ECB at the moment.