Do central bankers talk too much?
The louder a central bank talks, the more likely it is to hear its own echo. What's worse central banks risk ending up in a feedback loop where acting on signals from the market could distort those signals further.
That is the incendiary idea that Hyun Song Shin, economic adviser at the Bank for International Settlements, floated in a speech to the European Central bank conference on Tuesday.
If central banks talk more to influence market prices, he told the audience, they should listen less to the signals emanating from those same markets.
“Otherwise they could find themselves in an echo chamber of their own making acting on market signals that are echoes of their pronouncements," he told the audience.
In his speech, Shin noted that central banks are giving more speeches, holding more news conferences and embracing social media.
“However, communication is a two-way street It is not just about talking. It is also about listening.
"There is something of trade-off. More of one implies less of the other.”
“How many times have we heard the argument that the market is pricing in this or that action of the central banks and that any deviation would upset the market?
“This type of argument neglects how market participants have become conditioned to the way they interact.”
The more a central bank whispers in order not to upset markets, Shin claimed, the more market participants lean in to hear better.
During the speech, the high-profile economist said predictability might not be a virtue if market players take it as a commitment not to pull the rug from under their feet while they build up leverage and risk-taking positions.
In his opinion, even if there a more desirable equilibrium to the ‘whisper equilibrium’ the transition will be challenging.
“After all the ‘whisper equilibrium’ is an equilibrium precisely because market participants are leaning in to listen so intently and the central bank feels it has no better response than to whisper.
“Nor is it clear that the transition away from the whisper equilibrium to something more sensible becomes easier with time as the risk of upsetting markets grows with the accumulation of risk taking positions.”
Moving in lockstep
To demonstrate his point, Shin cited the inflation swap which has become more sensitive to short term economic news, especially economic news emanating from the central banks.
“This is so even for long-dated swaps that in theory should not be buffeted by short term moves,” he told the audience.
Most intriguingly, he went on to say, the inflation swap rate has begun to move in lockstep with the coupon rate itself.
To Shin, one possible explanation for the co-movement is the impact of central banks’ forward guidance
Cleraly, low and falling long-term yields are a sign that investors are anticipating lower growth and inflation, and a central bank policy response to try and turn that around.
"If the central bank lets it be known that the inflation swap rate enters future monetary policy actions, market participants will anticipate easier monetary policy when the inflation swap rate falls and chase nominal yields down.
Normalising monetary policy
“This type of front running may be so effective that the central bank need not follow through with any actions of its own.
“Signalling its contingent plan of action would be enough."
This would have important important monetary policy implications, Shin argued.
“When the bond market is subject to overreactionsm central bank forward guidance becomes more potent not least because of more vigorous front running by market participants
To conclude, Shin told conference members that this raises the question of how things will play out when central banks normalise monetary policy.
“The amplification channels that pushed rates down so effectively could equally work in reverse.”