Has the Yellen announcement come at the worst possible time?

The nomination of Janet Yellen to succeed Ben Bernanke as Chair of the US Federal Reserve comes at one of the riskiest moments in the recent history of the Fed

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The Fed’s announcement in May that it might start tapering its long-term asset purchases surprised many central bankers, and triggered a sell-off from markets worldwide. But some of the good news about America’s economy was bad news for financial markets, because investors considered the Fed’s potential policy tightening in response to such news to be more relevant than the news itself.

Then, in September, when the Fed postponed its withdrawal from so-called quantitative easing, markets quickly turned euphoric. Indeed, investors today appear less concerned about the real economic story than about the Fed’s interpretation of it. This underscores an important risk that Janet Yellen must now reckon with as she guides US monetary policy: in the longer run, the dominance of the Fed’s views in the market may cause serious economic harm.

Indeed, investors today appear less concerned about the real economic story than about the Fed’s interpretation of it

The problem for the Fed and other central banks lies not in monetary accommodation, but in their communication strategies. Their extensive promises, assurances, and pre-commitments have lured market participants into a false sense of security. This has induced market players to take on the wrong types of risk, leaving them poorly prepared for adverse changes in the economy and posing a broader threat to long-term financial stability.

Central banking is all about managing market expectations. Monetary authorities have, in recent years, made the way they communicate – about their thinking and possible actions – their primary tool to guide markets and anchor expectations. This is especially true of so-called forward guidance on policy rates – and increasingly so as central bankers’ scope for policy action has become more limited.

Unfortunately, major risks and costs arise from over-reliance on communication strategies. Because the voice of central banks has become so dominant in financial markets, price movements have come to reflect responses to their statements and actions, rather than to changing economic and financial realities.

For example, when policymakers promise to act if certain risks arise, markets inevitably discount the impact of such risks. In May, current Fed chairman Ben Bernanke issued an unusually stern warning about excessive risk-taking in financial markets. Yet investors have pushed equity indices to all-time highs, despite the feeble and uncertain recovery, while the VIX index, a proxy for investors’ perceptions of risk, fell to levels not seen since the boom years of 2005 and 2006.

A second consequence of the dominant role of central banks’ communications in financial markets is that it crowds out private sources of information, thereby depriving the monetary authorities themselves of an invaluable, independent view of trends that they need for sound policymaking. Worse, private actors no longer see the need to collect, analyze, or deploy their own information to the extent that they once did.

A third drawback is that when central banks are seen to give misleading assurances and to over-commit to certain outcomes, they risk losing their most important asset: their credibility. What will the Fed do, for example, if inflation rises sharply, but unemployment remains high? The Fed’s inability to anchor expectations would not only harm its credibility with investors, but would also make it much harder to fulfill its dual mandate of pursuing price stability and maximum employment.

These drawbacks apply to central banks’ forward guidance generally, and are leaving them hostage to fortune. The recent failure of the Bank of England’s guidance to move markets in the desired direction might mean that investors are more optimistic about the British economy. Or it might mean that central-bank guidance was ineffective, jeopardizing the BoE’s credibility. The European Central Bank faces similar risks.

For central banks, planning the exit from an accommodative policy stance is less important than exiting their current communication strategies. They should start withdrawing from their overly explicit policy commitments and attempts to micro-manage financial markets. Specifically, they should stop giving forward guidance, including announcements about when they will begin to tighten monetary policy and by how much. They need to reintroduce true two-way risk, so that asset prices again reflect underlying fundamentals.

Rather than trying to nudge investors toward certain outcomes and explicit numerical targets, Yellen and other central bankers need to communicate more clearly how they think about risks and opportunities in the economy and financial markets, and then let private investors decide the balance of risk and reward for themselves. This would help markets become more self-sufficient and resilient, thereby enhancing financial stability and providing support for economic recovery.

Marcel Fratzscher, a former head of International Policy Analysis at the European Central Bank, is President of the German Institute for Economic Research (DIW Berlin) and Professor of Macroeconomics and Finance at Humboldt University, Berlin.