MNI INTERVIEW: Uncertain Times Require Flexible Rates Guidance

Central banks with more rigid guidance such as the Bank of Japan run a higher risk of “coming unstuck” and feeding volatility in times of high uncertainty than those like the Federal Reserve which opt for a more ambiguous approach, a former Reserve Bank of New Zealand assistant governor told MNI.

While luck will play a significant role for global central banks over the next few quarters, the situation is fluid and it is reasonable for guidance to stress that future rate rises are "data dependent," John McDermott, executive director at Motu Economic and Public Policy Research, said in an interview. McDermott was RBNZ Assistant Governor between 2007-2019.

Central banks which provide signals with less conviction and more nuance on “fine-tuning” are likely to fare better than institutions committing to a course of action, he said. “I think the [Bank of Japan] is in a very tricky situation, because it has inflation well above target alongside ultra-easy policy and it has said it’s not moving until other conditions are met,” McDermott noted. “That's a rigid approach. That's very dangerous. It has set itself a high bar to move.” (See MNI POLICY: Weak Yen A Factor As BOJ Considers Policy Shift)

In contrast the Federal Reserve, which held rates steady at 5.25-5.5% last week, considers it has likely hiked enough, but has left a door open to further tightening in order to limit market volatility if it has to tighten again, he said. “If things calm down, then there’s no damage done,” McDermott said. “Now the Fed says the environment has changed, ‘let’s just see where we are, but flag the risk that there’s more to come.”

The Fed’s high-for-longer message saw U.S. bond yields climb to an 18-year high, while the S&P 500 declined about 2.4%. (See MNI BRIEF: Powell Ready To Hike Further If Appropriate)

POLICY MUST BE FLEXIBLE

In the case of the Reserve Bank of Australia, its strategy would have seemed more solid if oil prices had continued to decline, he said. “But they have to adjust course now and that could spike the market and create volatility,” he added. A few weeks ago the RBA may have “gotten away” with doing minimal rate hikes. “It looked like being patient could really pay off for [the RBA], but there is risk now – imagine oil at $100 a barrel and the RBA still has an inflation problem, consumers could get hit with a with a nasty shock.”

Central banks must maintain their ability to adapt as economic conditions change rapidly, McDermott argued. (See MNI INTERVIEW:Flat Rates Fit With Data Dependence-ExBoe's Bean)

“Other central bankers have made their career by holding a firm commitment, being clear and providing forward guidance because that shapes markets in a way that helps monetary policy,” he continued. “There are times when making a commitment and sticking to it is a very powerful tool for central bankers. But that's not how they should play all the time. The world is different now and they have to move away from firm forward guidance to a world ready for change. It's easier said than done.”