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Roula Khalaf, editor of the FT, picks her favorite stories in this weekly newsletter.
The author is Chief Economist for Europe and Head of the Investment Strategy Group at Vanguard, Europe.
Interest rates won’t go back to zero – central banks know it, bond markets have priced it in and stock markets fear it. Central banks should do more to communicate this.
But it’s not just what central banks say that matters, but also how they say it. In a recent article, Haroon Mumtaz, Roxane Spitznagel and I examine how asset prices move following Bank of England communications – speeches, monetary policy announcements and press conferences.
We find that asset prices respond differently to how new information about the future course of policy is communicated. Speeches by members of the Monetary Policy Committee have a greater impact on medium- to long-term Treasury yields than interest rate announcements and press conferences.
The evidence is stronger for the US. The Federal Reserve would rather not surprise the markets. Fed Chair speeches are more important than FOMC announcements in boosting US stock prices and bond yields beyond the shortest maturities.
Measuring good communication is not easy. However, complex communication tends to lead to greater volatility in asset prices, which is undesirable from a macroeconomic perspective.
The problem is of course complicated. The cause of complex communication could be poor choice of words and a lack of clarity of thought. But it could also be a challenging economic environment. This would make it harder to predict where the economy is headed and make an appropriate policy response more difficult. For example, when the economy was hit by shocks such as the pandemic and the war in Ukraine, central banks had to work with new concepts and data to determine the best policy course. Based on the language structure and words, we find that the Bank of England’s communications have become more complex over time as the environment has become more sophisticated. Complex communication could also be the result of conflicts between members of the Monetary Policy Committee: it may be difficult to convey the different views in a simple way.
But the importance of communication is especially important now as markets debate how long high interest rates will last. Luck and good policy have been discussed as key drivers of the Great Moderation of 1987-2006 – a period of economic stability and low market volatility. Following the pandemic, the war in Ukraine and ongoing geopolitical tensions, there are concerns that we are entering a period of great volatility.
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The cyclical and structural component of interest rates has undoubtedly increased. The cyclical nature of interest rates is determined by the central banks. When inflation is high and growth is robust, central banks set interest rates above the neutral rate – the level at which the economy runs at equilibrium, also called the R-star. That’s today’s story. The Fed, European Central Bank and Bank of England have said interest rates are restrictive and will remain so for some time.
We expect interest rates to fall from their cyclical highs in 2024. When the economy returns to equilibrium, the cyclical component will fall to zero. However, our research shows that the neutral real interest rate in the United States has increased by about 1 percentage point since the Great Recession following the 2007-2008 financial crisis to about 1.5 percent today, leaving the neutral nominal interest rate at about 3.5 percent. Internal estimates suggest that neutral interest rates in the UK and the euro area have increased by similar amounts.
Average interest rates over the next decade will therefore be significantly higher than the average over the last decade. If true, it will have profound implications for governments, markets and investors.
The Federal Reserve uses its dot plots of individual forecasts to provide forecasts of what its policymakers think longer-term interest rates will be. But the Fed has been slow to change its call for a neutral interest rate: its longer-term interest rate was above 4 percent in 2012 and only fell below 3 percent in 2016, which is what a neutral policy stance looks like.
This is due to fear of doing something wrong and uncertainties in estimating the R star. However, good communication – that is clear and simple – is a possible way to mitigate volatility and provide financial markets with an anchor for medium-term interest rates. Simply put, speeches help monetary policy do its job. Timely communication of the neutral political framework is crucial. It influences asset prices and financial conditions, an important channel for the transmission of monetary policy. Policymakers can do better. You should take the neutral rate and talk about it.
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