Two More Lessons on Monetary Policy's Unpredictability

What happens when two monetary policy institutions pause rate hikes, say some things alluding to easing their fight against inflation, then U-turn and hike rates? Evidently, what happens is financial commentators keep parsing their statements for clues as to what will happen next, as if policymakers didn’t just demonstrate what we think was the fruitlessness of this endeavour. So it goes this week, with many commentators we read trying to project what the Reserve Bank of Australia (RBA) and Bank of Canada (BoC) will do next after the week’s hikes. Dear readers, we suggest you not fall into the same trap—if monetary policymakers can’t predict their own moves, how can mere mortals?

To see this, let us start with the RBA and simply take a tour of its recent policy decisions and statements. In February, as the bank hiked its policy rate by 0.25 percentage point (ppt) or 25 basis points (bps), Governor Philip Lowe’s statement said the bank’s “Board expects that further increases in interest rates will be needed over the months ahead.”^[i] So none of the commentators we follow appeared too surprised when the RBA hiked again in March—or that Lowe’s March statement said the “Board expects that further tightening of monetary policy will be needed to ensure that inflation returns to target and that this period of high inflation is only temporary.”^[ii] But then the RBA paused in April, surprising many observers we follow. That month’s statement referred several times to slowing economic growth, falling inflation forecasts and monetary policy’s tendency to hit the economy at a lag. The forward guidance—a fancy term for what monetary policymakers say they anticipate doing—also got more dovish (or non-rate-hikey, if you aren’t into overused bird metaphors), saying more rate hikes “may well be needed.”^[iii] Not “will,” just “may well.” Many analysts we follow said this likely meant rate hikes were off the table for the time being.

Surprise! The RBA hiked by 0.25 ppt in May, defying many commentators’ forecasts for more pausing.^[iv] What changed? Governor Lowe’s statement explained that after assessing rate hikes’ impact, the Board decided it would take too long to get inflation back down to target if they didn’t resume hiking. Yet their guidance was still what we would describe as squishy, saying more rate hikes “may be required.”^[v] Evidently that was indeed the case, as they hiked another 0.25 ppt Tuesday despite a raft of slowing economic indicators.^[vi] And they have kept the “may be required” guidance, spurring many observers we follow into another round of what will they do next?^[vii]

We just don’t get it. “Will be needed” preceded hikes and a rate pause. “May well be needed” preceded a hike. “May be required” preceded a hike. In our view, none of it means anything, because—as every statement acknowledges—decisions depend on the evolution of economic and inflation data. From what we can see, these individuals are reacting to changing economic indicators and forecasts based on their biases and viewpoints and how those influence policymakers’ forecasts, which, in our experience, are always impossible to pin down exactly.

For lesson two, see the BoC, which hiked Wednesday after pausing in March and April. When they last hiked in late January, the Governing Council said that if the economy performed in line with their forecasts, they anticipate holding “the policy rate at its current level while it assesses the impact of the cumulative interest rate increases.”^[viii] But they also left the door open for more hikes “if needed to return inflation to the 2% target.” So March’s pause wasn’t a huge surprise to observers we follow. Neither was April’s, with both statements focussing on moderating inflation and weak gross domestic product (GDP, a government-produced measure of economic output) forecasts. Both statements also said the Governing Council “remains prepared to raise the policy rate further if needed to return inflation to the 2% target,” but with nothing like the clear-cut guidance in January’s statement, commentators we follow broadly didn’t project another hike.^[ix]

So of course they hiked this week! And jolted Canadian bond markets in the process, sending interest rates up more than 15 bps across all maturities through 10 years.^[x] The statement said the economy was running hotter than anticipated and conceded monetary policy to date “was not sufficiently restrictive to bring supply and demand into balance and return inflation sustainably to the 2% target.”^[xi] For those investors who don’t speak monetary policymaker-ese, we translate this as oopsie daisy. And perhaps aware that their past forward guidance wasn’t terribly useful, they didn’t even try to set expectations—instead, they just rattled off what they are watching for.

But that didn’t stop analysts we follow from trying to read the tea leaves. Futures markets quickly priced in another 0.25 ppt hike by September’s meeting.^[xii] We anticipate reporters will grill Deputy Governor Paul Beaudry about the BoC’s next move at the speech and press conference he is holding Thursday.

Some unsolicited advice we think would be valuable for him: Don’t cave. In our view, jettisoning forward guidance is a good thing. We think the less policymakers commit to, the fewer U-turns they likely have to make, and the more opportunity to store up credibility. When contrasting monetary policymakers’ guidance with their decisions over the past 15 years, we find they have defied it repeatedly. When former Federal Reserve Chair Ben Bernanke popularised forward guidance many years ago, the stated intent was to increase transparency—a goal many commentators we follow cheered at the time. ^[xiii] But as time wore on, it earned mockery from many analysts and politicians globally for the frequent mind changing and, in one infamous exchange with Members of Parliament, the moniker “unreliable boyfriend” for former Bank of England chief Mark Carney.^[xiv]

We think if more monetary policy institutions stopped trying to preview their next moves—and commentators we follow stopped trying to guess what comes next—we would probably all be happier. We think markets could go about their daily business of pricing in developments and data signals. Speeches would likely get far less attention, so we would get far fewer of them. In our view, monetary policy institutions could rebuild credibility. We think analysts could use automation and AI for things other than unnecessarily parsing monetary policy institution members’ statements for small wording differences that we don’t think indicate anything about what they will do. All good things, in our view, except maybe that last one, which we think is pretty neutral.

But for now that seems to be a pipe dream, so let us all remember, always, that, in our view, forward guidance isn’t reliably predictive, monetary policy isn’t predictable and interest rate decisions have no pre-set market impact. In our experience, monetary policymakers do what they do when they do it, and our research shows it hits the economy at a significant lag, which we think gives investors plenty of time to assess the merits and reposition, if necessary, after the fact.^[xv]