Whatever central banks say has an impact. Their communications and statements are needed because there is a lot of confidence in central banks. In the latest Bank of America survey, institutional investors were reported as saying that by far the most important variable for the near-term performance of equity and fixed-income markets is the monetary policy of central banks.
Central banks make use of voice communication to back up part of their activities. Formal statements and informal talk are used to buy time, since information on the state of the economy accumulates gradually with some delay. If central bank policies consisted exclusively of actions, their weapons arsenal would be so much poorer.
Change at the end of 2023
The term "dovish pivot" is used to describe monetary policy at the end of last year. This means that the tightening monetary policy pursued by the central banks continued until the summer (USA) and early autumn (euro area), and the latest announcements, speeches and accumulated data suggested an end to monetary tightening. The markets made an even bolder interpretation expecting an earlier cut in interest rates than previously foreseen. This was then reflected in lower interest rates and an excellent performance by equities in the last quarter of 2023. For example, November 2023 will go down in recent history as one of the best months for institutional investors.
Was this something that the central banks wanted? The answer depends on the timeframe. Central banks buy time. Procrastination is valuable because the effects of decisions are felt with a delay. Moreover, it gives more time for considering further action. In recent months, the markets have been listening to central bankers’ responses to market reactions. The latest message is that the markets have adopted an excessively aggressive stance in anticipation of future decisions by central banks.
Thought experiments
We could toy with the idea that central banks acted differently. Off-hand, I can think of four different scenarios: Making decisions without talking about them; talking without making decisions; automating central bank decisions; or believing what the markets are saying. Let’s see if these options are viable.
The first thought experiment presupposes that central banks say nothing. It’s possible, if they behaved like the papal conclave. The cardinal electors responsible for electing a new pope convene and once the decision is reached, white smoke emerges from the chimney on the roof of the Sistine Chapel. In the world of central banks, making decisions without making any announcements would mean that decisions would have to be taken more often to give additional signals as to future action. In the absence of formal statements, several decisions would be required to glean information and scan market reactions.
The second scenario assumes that a central bank makes policy just by talking. If the central bank enjoyed enough credibility and the market conditions were sufficiently favourable, monetary policy could, for a while, be directed by talk alone. However, it would not work for any length of time, because actual interest rates alone do make a difference. Of course, if the bank rates were adjusted only once a year, it would lead to a lot of talk in order to ensure that the economy would not overheat in between rate decisions and to avoid excessive braking in the opposite case.
The third scenario relates to the automation of central bank decisions. Now that AI is evolving by leaps and bounds, we can of course toy with the idea of whether AI would be able to do the central bankers’ job. Could AI perhaps outdo central bankers? The answer would probably depend on the complexity of the central bankers' mandate. If there was only one parameter that the central bank watches single-mindedly, AI would probably be an efficient tool. In reality, central bank mandates are written mandates, seasoned with
realpolitik
. A complexity-ridden objective combined with expectations that change over time would make AI-driven central bank policy difficult. Most likely, artificial intelligence will remain a background toolkit and serve as a tool for investors trying to foresee the future.
The fourth option is to believe in market pricing and make decisions accordingly. If we believe that the market is right, we could think of taking our cue and the decision-making parameters from the marketplace. However, reality imposes a number of challenges. Market architecture has its own impact, just like the time-dependent fluctuations in supply and demand. Markets may also be plagued by short-sightedness. At times, market prices may reflect optimism or strong realism. Often, however, market prices are an excellent signal of what central bankers may be thinking at the time ... until they think otherwise.
In conclusion
A central bank cannot be replaced by a Vatican chimney or artificial intelligence. However, they do exhibit two important aspects of a central bank. Decision-making by a central bank calls for massive amounts of data currently being processed by computers and AI. At the same time, papal wisdom and trust is required to serve as a basis for decision-making to ensure that the markets interpret central banks the way they are supposed to. Trust is a powerful tool, something that central banks rely on to a great extent.
Several decisions may substitute for several announcements, but announcements cannot substitute for decisions for any length of time. Decisions are needed when reality is at odds with the bank rate. This type of situation arises when the inflation rate falls low enough relative to the central bank rate. Then it would be necessary to act.
The recent "dovish pivot" debate will continue. By their March meetings, central banks will have accumulated more data for computer analysis. Meanwhile, investors try to discern the future. Some experts now believe that there will be a real change in interest rate policy, in other words, interest rates will fall, at least in the euro area. That decision, just like many others, may be supplanted by talk for a while. However, it is the markets that provide the best daily summary of what is going on in the collective minds of central bankers at any given moment.
Writer is VER's CEO Timo Löyttyniemi.
