2023 OUTLOOK
TEN COMMENTS TO LOOK AHEAD TO THE CHALLENGES OF THE NEW YEAR. FIFTH CHAPTER: MONETARY POLICY. EVEN MORE THAN INTEREST RATES, WE NEED TO THINK ABOUT ITS TRANSPARENCY. THE REASON IS THAT THE EFFECTIVENESS OF MONETARY POLICY DEPENDS ON ITS ABILITY TO INFLUENCE THE EXPECTATIONS OF HOUSEHOLDS, BUSINESSES AND MARKETS. AND THAT ABILITY IS IN TURN LINKED TO CENTRAL BANK ANNOUNCEMENTS.by Donato Masciandaro, Full Professor of Monetary Economics, Intesa Sanpaolo Chair in Economics of Financial Regulaton
Translated by Alex Foti
All those wondering about the future of monetary policy in Europe and the United States have only one question in mind: what will be the tune of interest rates? In reality, the essential question is another. Since the effectiveness of monetary policy depends on its transparency, to quote Shakespeare, who will prevail: the larks, who love light, or the nightingales, who prefer opacity?
Why will the issue of transparency always be crucial in the months to come? We assume that the common goal of central bankers is to protect monetary stability, minimizing recessionary risks. In this case, all central bankers should play larks.
The reason is that the effectiveness of monetary policy depends on its ability to influence the expectations of households, firms and markets. This ability is in turn linked to the announcements coming from the central bank. The announcement is good if it causes the Ulysses effect: the operators believe in the central bank, and do what it wishes for. Actual example: In July 2012, Draghi utters a sentence, short and generic, and provokes a virtuous reaction: everyone believes that the euro is irreversible.
The importance of having announcements with Ulysses effects is an axiom that always applies, but it will particularly hold true in 2023, when the dominant trait will be uncertainty. Expectations need a monetary policy that provides security, not that contributes to increased instability. Therefore, there must be maximum transparency in the so-called reaction function of monetary policy. Central banks must announce binding rate policies, based on their macroeconomic forecasts, but always revisable, in the light of new relevant macroeconomic data. Let's take the example of Frankfurt. We can imagine a lark ECB announcing a path of at least six months on interest rates and liquidity, and at the same time defining which macroeconomic data will be considered in case a change of course is appropriate.
Conversely, we can have a nightingale ECB, which is not bound to any path, and hides behind the formula of making decisions depending on the data, without even specifying which ones, following the so-called "holistic" approach, i.e. a pompous way of saying hot air. In this case, the announcement policy becomes bad, and the Delphi effect prevails: the central bank offers information that causes operators to react differently from the desired outcome, because the proposed monetary policy is not convincing. It happened to the ECB last September.
Christine Lagarde seemed to be groping in the dark as she communicated the choices of the ECB: a widely discounted decision to raise current rates, seasoned with empty words about the future. More than giving a credible message, the goal seemed to be to get by and buy time. No wonder the response of the markets has been negative. An the Fed is no better off. In October Powell uttered a sentence of the same length and generality as Draghi's "whatever it takes", but the result was the opposite: no one seems to believe that the Fed will be able to contain inflation without creating recessionary risks. Draghi is to the Ulysses effect what Powell is to the Delphi effect.
Both the ECB and the FED are playing nightingales instead of larks. Perhaps by saying that the job of central banker is an art, given the intrinsic limits of mathematical models. This is sad, because we seem to have gone back a century and a half, when economics was still in its infancy, and central bankers were government-controlled bureaucrats. Today they are independent authorities, at the service of citizens, with the obligation of transparency. Let's hope they remember this.
