Tuesday, October 2, 2007

Thinking Like a Central Banker -if only it could be that easy

William Poole, the President, Federal Reserve Bank of St. Louis gave a speech in New York last week which was very insightful for those who want to take a long view of monetary policy. It is available on the St Louis Fed website, http://stlouisfed.org/news/speeches/2007/09_28_07.html.
This speech is a good review of how central bankers think. It does not provide a telling of the inner workings of the Fed but tries to provide an overview on what is the thought process for the central bank and contrast their work with those of private firms. While investors are trying to figure out what will be the nuances in policy from the next FOMC meeting, Poole wants everyone to step back and consider that the Fed is trying to send clear messages and does not want to confuse the markets. There should be no surprises. If there are surprises, then the Fed has not done its job of sending a clear message. I have taken excerpts from the speech because his message is critically for understanding how the Fed thinks on a macro level.

1. Central bankers do not sweat the daily data. While there is significant data analysis done at the Fed to prepare for FOMC committee meetings, most FOMC members do not track the daily or hourly movements in the same way as investors.

Traders and portfolio managers base their trades on the current flow of information, which needs to be updated throughout the trading day. Fed policymakers, on the other hand, do not continuously adjust the stance of policy in the same way managers adjust portfolio holdings.

2. The choices of the central banker are limited, so major changes or adjustment in policy are unlikely to happen.

One important difference between a financial firm and the central bank is that a firm has a much wider array of strategies available to mitigate risk than does a central bank… A central bank pretty much has to accept policy risks to the economy arising from the economy’s institutional structure and market environment.

3. Reputational risk is paramount. The Fed always has to worry about perception and trust. Hence, there is a natural level of conservatism in the actions they take.

A risk that is often incompletely understood by those outside management is reputational risk. The issue is much more than simple embarrassment. Trust is an essential capital asset for a financial firm and for a central bank.

4. Central bank focus on interpreting what are market expectations. They are constantly trying to understand how the market will react to a policy message. They do not want market surprises.

There is an important policy purpose for the Fed to study these market expectations. Understanding how the flow of new information affects market expectations can be useful to policymakers.

5. The objective function of central bankers is focused on minimizing losses. There is no profit maximizing behavior. Central bankers focus on differences or loss from inflation and from growth.

Policymakers think in terms of a loss function that depends on departures of outcomes from desired outcomes.

6. The central bank is a price maker, or would like to have this power. They will try and move markets and expectations to meet policy objectives.

What is a critically important difference between a central bank and a private financial firm is that the central bank, in the short run anyway, sets a policy interest rate and, importantly, influences longer-term interest rates though effects on market expectations. The central bank is a price maker in the interbank funds market. Private financial firms are essentially price takers in that market and in the government securities market.

7. Central bank looks for consistency. There is no secret agenda or effort to surprise the market.

What is important is not the policy action at the next FOMC meeting, which is typically what people want to know, but the policy regularity that will extend across many FOMC meetings, which is what people should want to know.

An important corollary to the task of defining a policy rule is that the central bank ought not to be a source of random disturbances.

The Fed is not completely knowable but they do want to be as transparent as possible. Policy should not be a surprise. There should not be a mystery and if the market is confused, the Fed should clarify their intentions.

Investors should stay calm before Fed meetings. This is not supposed to give anyone heartburn.

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