The Fed Has the Final Word8. July 2013 by Joachim Goldberg
I guess there were not many central bank watchers who expected the latest declaration by ECB chief Mario Draghi. At last week’s press conference, one inattentive journalist was so engrossed in his pre-prepared question as to why the ECB did NOT engage in the kind of forward guidance recently adopted by the new Bank of England governor, he had completed the missed the part where Draghi did precisely that. In fact Draghi’s new commitment to holding rates low for an extended period of time was identical to that promised by Mark Carney. One could forgive the journalist’s embarrassment, though, as Draghi’s declaration was a monumental break with a sacred ECB rule – one established by his predecessor, Jean Claude Trichet – namely, the Governing Council never pre-commits.
One could say that even Trichet only played lip-service to this rule. The Frenchman was famous for his ‘traffic-light’ system of code words. Prior to hiking rates, he would insert the words ‘vigilance’ or ‘strong vigilance’ into his press statements. Every observer knew then that a 25bp rate hike was two, respectively, one month away. The Governing Council never dared deviate from the promised monetary policy step once these code-words were uttered. I remember watching the April 2011 press conference in disbelief as Trichet delivered the rate hike promised in the two prior months even though the economic backdrop had changed unrecognisably in the meantime. ‘Why, Trichet, Why?’ we asked as the ECB stubbornly tightened monetary policy just after Japan had been struck by a tsunami and a nuclear accident, and Portugal had applied for an EU/IMF bailout.
This is precisely the problem with pre-commitment: one cannot easily change one’s opinion in response to changing conditions without a loss of face. In the case of Draghi, though, as he is only making a step that every other major central bank has already made, this is less of a problem: the psychological commitment is far greater when one does something that one has never done before, or does something that nobody else is doing. The pre-commitment does have one advantage though: it imposes discipline and prevents one from flip-flopping from one opinion to the next like a flag blowing in the wind. Clearly, therefore, it is better to pre-commit to objectives – like stable inflation rates – than to the means one intends to employ to achieve them.
At least market commentators seemed to have fewer problems with Draghi’s pre-commitment than with Trichet’s. This is probably because Draghi’s involves easy policy whereas his predecessor only ever code-worded policy tightening. This precisely where I have a problem. I see the ECB’s decision as purely a reaction to the rising global bond yields triggered by the US central bank’s decision to retreat from its quantitative easing policy. Of course, if eurozone long yields rise, this creates an unwelcome drag to the region’s economic recovery, which is clearly a matter for the ECB. However, this does not change the fact that the situation was created by the Federal Reserve Bank in the first place. This confirms that a handful of economists in Washington determine not only the monetary policy of the US, but that of the entire world.