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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is chief European economist and head of the investment strategy group at Vanguard, Europe.
Rates are not going back to zero — central banks know it, bond markets have priced it, and equity markets fear it. Central banks should do more to communicate this.
But it is not just what central banks say, but also how they say it. In a recent paper, Haroon Mumtaz, Roxane Spitznagel and I study how asset prices move following Bank of England communication — speeches, monetary policy announcements and press conferences.
We find that asset prices respond differently to how new information about the future path of policy is transmitted. Speeches by Monetary Policy Committee members are more potent in influencing medium to long run gilt yields than interest rate announcements and press conferences.
The evidence is stronger for the US. The Federal Reserve prefers not to surprise markets. Fed chair speeches are more important than FOMC announcements in driving US stock prices and bond yields beyond the very shortest maturities.
Measuring good communication is not easy. But complex communication tends to be followed by greater asset price volatility, which is undesirable from a macroeconomic perspective.
The issue is, of course, complicated. The source of complex communication could be a poor choice of words and lack of clarity of thinking. But it could also be a challenging economic environment. That would make it harder to forecast where the economy is heading and complicate the appropriate policy response. For example, when the economy was hit by shocks, like the pandemic and war in Ukraine, central banks had to work with new concepts and data to determine the best course for policy. Based on language structure and words, we find Bank of England communication has become more complex over time, as the environment has become more challenging. Complex communication could also be the result of conflict among members of the Monetary Policy Committee: it may be hard to convey the differences of view in a simple way.
But the importance of communication is particularly pertinent now, as markets debate just how long high rates will persist. Good 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, war in Ukraine and continuing geopolitical tensions, there is concern that we are entering a period of great volatility.
The cyclical and structural component of interest rates have undoubtedly increased. The cyclical stance of interest rates is set by central banks. When inflation is high and growth resilient, central banks set the policy rate above the neutral rate — the level at which the economy runs at an equilibrium level, also known as the r-star. That is the story of today. The Fed, the European Central Bank and Bank of England have said rates are restrictive and will remain so for some time.
Our view is that rates will recede from their cyclical peaks in 2024. As the economy returns to equilibrium, the cyclical component will fall to zero. But our research shows that the US neutral real rate of interest has increased by about 1 percentage point since the great recession after the 2007-8 financial crisis to around 1.5 per cent today, making the neutral nominal rate around 3.5 per cent. In-house estimates suggest the UK and euro area neutral rates have increased by similar amounts.
Average interest rates over the next decade will thus be significantly higher than its average over the past decade. If correct, this will have profound implications for the governments, markets and investors.
The Federal Reserve provides projections of what its policymakers think will be the level of longer run interest rates with its dot plots of individual forecasts. But the Fed has been slow to change its neutral rate call: its longer run interest rate was over 4 per cent in 2012 and fell below 3 per cent only in 2016. The ECB and Bank of England have been reluctant to give guidance on what a neutral policy setting looks like.
This comes from fear of getting things wrong and uncertainties around estimating R-star. However, good communication — that is clear and simple — is one potential way to mitigate volatility, providing financial markets with an anchor for medium-term rates. Simply put, speeches help monetary policy get the job done. Timely communication of the neutral policy setting is essential. It influences asset prices and financial conditions, an important channel for the transmission of monetary policy. Policymakers can do better. They should embrace the neutral rate and talk about it.