Central Banks and Monetary Policy: How Central Bankers Set Policy (Part 3)

UNCONVENTIONAL POLICY IMPLEMENTATION

Pipscollector.com - QE programs are implemented in the same way that open market operations are. Traders in the central bank’s policy implementation division publish announcements and schedules detailing their purchase plans. Their counterparties submit a list of bonds they are willing to sell to the central bank and the central bank’s traders select and transact with the most competitive bids.

While the internet is awash with central bank-focused money printing memes, the actual money created by the central bank in exchange for these bonds is electronic only. The accounts of transacting counterparties are credited with fresh digital money from the central bank.

COMMUNICATION IS KEY

Given the evolution of monetary policy implementation since the financial crisis, another important development in the central bank toolkit has been forward guidance.

Forward guidance is the communication of the future path of interest rates. The premise of forward guidance is simple: businesses, investors, and markets are constantly trying to predict the central bank’s next moves.

By clearly communicating their plans, central bankers can adjust expectations to their desired points and provide better clarity to markets. Forward guidance is linked to policy framework, applying the central bank’s view on key metrics to its communication about future policy.

Communication, transparency, and the setting of expectations has been a continually-evolving piece of central bank policy. Transparency on policy helps the central bank remain both predictable and credible, valuable standards to maintain for an institution with such power over the financial system.

The FOMC began to use forward guidance in the aftermath of the financial crisis, communicating that rates would be held at zero “for some time.” As the recovery continued, forward guidance language evolved to a dates-based approach and then an outcomes-based approach. Both approaches help to set expectations for policy over the longer-term and have proved useful for central banks around the world.

Central banks have turned to forward guidance again in the Covid crisis, providing markets with clear communications of rate outlooks, tapering expectations, and asset purchase program paths.

For its part, the Federal Reserve has continued to stick to guidance consistent with their new framework despite strong economic data and market worries of inflation. FOMC members have affirmed that tapering and rate hikes will not come until substantial progress is seen towards the Fed’s goals.

SETTING POLICY, SUMMATION

Central bank policy has evolved a great deal over the past two decades. While the data that central banks track in order to formulate policy has not changed much, the way that policy is implemented has evolved a great deal. The development of secular trends following the financial crisis has also created the need for new innovations in policy.

Central banks now control rates and monetary policy more generally through the management of liquidity, through large-scale asset purchases, through technical tweaks to money markets, and through enhanced communication.

Understanding how these components interlock and weigh on each other and their impact for overall financial markets is valuable knowledge for any trader.

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