Deutsche with the note:
I’m going to open the market section this morning with a line I don’t think I’ve written in 27 years of market commentary and probably won’t again. And it’s not about England thrashing Australia at cricket on Saturday. Yes the most important event of the week could be the RBA meeting tomorrow.
[I have] absolutely zero idea what they are going to do tomorrow which should help you all tremendously but their absence again this morning gives a decent indication. I was taught economics in an era where central banks liked to keep an element of mystery and surprise. As such I’ve always disliked the forward guidance era as it encourages markets to pile on to much riskier, one way positions that a normally functioning market should naturally allow. But to go from forward guidance to silence (that rhymes) is a recipe for huge market turmoil if the facts change.
It’s unclear if the full implications of last week’s carnage at the global front end has yet been cleared out. There is lots of speculation about large unwinds, big stop losses etc. Liquidity was also awful last week. Much might depend on central banks this week. Make no mistake though there is considerable pain out there.
In another not, Deutsche expands on why the RBA meet is so important:
As pointed out by our FX colleagues,the market is undergoing a VaR shock which is difficult to interpret from a macro economic perspective. However, if there was to a be an “original macro sin” for such moves, it would be the excessive reliance of central banks on forward guidance.
While forward guidance is hailed by central banks as a great monetary policy tool, when close to the lower bound it suffers significant drawbacks. Indeed, using as an example the ECB situation as summarised in our ECB preview, there are intrinsic limitations to the forward guidance.
First and foremost and as pointed out by Jeremy Stein, forward guidance may end up being self defeating: “There is always a temptation for the central bank to speak in a whisper, because anything that gets said reverberates so loudly in markets. But the softer it talks, the more the market leans in to hear better and, thus, the more the whisper gets amplified. So efforts to overly manage the market volatility associated with our communications may ultimately be self-defeating.
“Second, to be more “credible” the ECB would need to adopt a calendar based forward guidance (or equivalently as the RBA did a target for e.g. 3-year rates). However, this will imply a degree of certainty that central banks should be wary of pretending to have. It would be the equivalent of doubling up in a difficult position. It could solve the issue in the short term, but will increase the stakes when either (1) time will comes from exiting this reinforced forward guidance or (ii) facts challenge the forward guidance (cf. the RBA).
Third, the forward guidance is ultimately based on the ability to forecast inflation. A lot has been written as to why inflation has been low in the past decades. Inflation expectations being adaptive, the conclusions have been extrapolated to the indefinite future. But little credit has been given to the fact that inflation is subject to regime shifts which can be generated by (a) monetary and/or fiscal policy shifts or (b) exogenous supply shocks. In particular, coordinated monetary and fiscal policies is the textbook way of generating inflation. Therefore, in presence of a very pro-active fiscal policy following Covid, introducing a new monetary policy framework predicated on years of low inflation is the theoretical perfect combination to create a challenging environment for forward guidance. Some credit should also be given to the uncertainty generated by the potential negative supply shock associated with addressing climate change.
Fourth, in the case of the Fed, the forward guidance is also predicated on the ability to forecast NAIRU. A causal look at historical revisions of estimates of NAIRU highlights the degree of uncertainty associated with it. In fact, as NAIRU is derived ex-post from the combination of the observed level of unemployment and inflation, estimates will turn out to be backward looking and ignoring the regime shifts that could impact inflation. For instance, as we highlighted several times, the US labour market is currently behaving as if was through full employment. It may very well turn out that following the US mid-term elections a significant fiscal tightening will force inflation back lower. But this should not distract from the fact that an excessive reliance on forward guidance is not the silver bullet that current central bank rhetoric suggests.
Hmm, well, given the RBA is unable to forecast its way out of s wet paper bag, dependence upon any kind forecasting for setting expectations is deeply troubled.
That said, I maintain that the mistake here is the RBA (and Deutsche) seeing short-term market distortions and inflation hysteria as “facts”.
As a result, the RBA’s collapsed forecasting credibility is now expressing itself as collapsed self-confidence and resulting in a central bank that has NO IDEA WHAT IT IS DOING.
Bring on that RBA review which will no doubt be every bit as dull as the bank itself.
