The implications of central bank credibility on asset allocation decision-making. The case of G4 central banks

I am grateful to all those who helped me in conducting the survey as well as to the survey respondents. I would also like to express my gratitude to Lucian Croitoru, Mihai Copaciu, Victor Andrei, Dragos Popescu, Adrian Dudu, Adrian Costea, and Andrei Secuesu for their useful comments and insights in connection to this article. All opinions and views expressed hereunder belong to the author and are not necessarily endorsed or shared by the National Bank of Romania.

Abstract

Over the last decades, many studies have been conducted around the concept of central bank (CB) credibility. Intense research has been deployed also for gauging the effects of the monetary policy stance on financial market developments – recently, the focus was on the non-standard instruments engaged by the major monetary authorities. This article addresses the implications of central bank credibility on asset allocation decision-making. No seminal paper did this (to the best of my knowledge). The approach is qualitative in nature and the focus is on the G4 CBs and the asset allocation decision-making of the conservative investors. I show that the credibility of the G4 CBs has been impaired lately. According to the respondents of the survey I conducted among financial market practitioners, the most important contributor to the credibility loss is represented by the reduced monetary policy effectiveness observed over the last years. The survey results confirm that the level of central bank credibility is both relevant and important for the asset allocation decision-making. The implications of the impaired CBs credibility on the asset allocation decision-making of conservative investors might be significant, both at a strategic and tactical layer. I believe that more focus will be placed on risk diversification at a strategic layer, while the general tactical approach will probably be more dynamic and opportunistic than would otherwise be the case. In essence, I expect a somehow more prudent and flexible risk taking approach in the following years due to the impaired CBs credibility (ceteris paribus).

Introduction

It is broadly accepted that the success of monetary policy comes from the CBs ability to manage effectively market expectations. But without being credible, a central bank cannot properly manage expectations. Mario Draghi, the ECB president, reiterated in April 2016 how important is for a CB to be credible: “any time the credibility of a central bank is perceived as being put into question, the result is a delay in the achievement of its objectives, and therefore the need of more policy expansion.” In other words, in order to achieve effectively its monetary policy objectives, a CB must be fully credible.

Defining and measuring the credibility of a CB is challenging. Alan Blinder offered the following definition as being his favorite one: “A central bank is credible if people believe it will do what it says” (Blinder, June 1999). Ultimately, a CB is credible if market participants trust its ability and commitment to achieve its objectives effectively, according to its mandate. For gaining and maintaining the right level of credibility, a CB has to deploy a constant and intense effort to build confidence with respect to its objectives, judgment and decisions. The quality of the communication policy is essential in this process.

The credibility of major CBs appears to have been impaired lately. How seriously? Which are the main explanatory factors? Is the level of central bank credibility a relevant input in the asset allocation decision making? How important is it? And what are the implications of the impaired CBs credibility on the asset allocation decision-making of the conservative investors? These are the questions I address in this paper.

In section 2 some red flags as regards the credibility of the major CBs are pointed out. The most relevant red flag is probably represented by the persistency of the very low market-based inflation expectations in the main advanced economies after years of highly expansionary monetary policy stance. Section 3 presents the results of the survey conducted among market practitioners and confirms the hypothesis of the impaired G4 CBs credibility. The most important three contributors to the loss of G4 CBs credibility pointed out by the survey respondents, in order of importance, are: (i) the reduced monetary policy effectiveness observed over the last years, (ii) the moral hazard and market distortions associated with the aggressive non-conventional monetary policy easing measures adopted post crisis, and (iii) the inconsistencies between monetary policy signals/pre-commitments and subsequent actions. Section 4 discusses the role of monetary policy stance within asset allocation decision-making. This topic is relevant because - in essence - the level of central bank credibility affects the asset allocation decisions mainly via its impact on the market perception related to the monetary policy framework effectiveness. Section 5 shows that the central bank credibility is both relevant and important for the asset allocation decisions. Here I stress out that the level of CBs credibility feeds into the asset allocation decision-making through three channels which I briefly describe. In section 6 I express my view regarding the implications of the impaired CBs credibility for the asset allocation decision-making of the conservative investors. Section 7 concludes.

Red flags as regards the credibility of the major central banks

In June 2014, the ECB entered a new monetary policy easing phase – a very aggressive one - to revive inflation[1]. More than two years passed and the inflation rate in the euro area is even lower (slightly above zero) while the market based inflation expectations are close to the historical minimum levels. Low inflation dynamics are also observed in Japan where ample discussions are taking place regarding the opportunity of using “helicopter money” for avoiding the installation of a new deflationary spiral. Achieving the price stability objective has been challenging in other advanced countries also, including in the UK and, to a lower degree, in the US.

The persistency of the very low market-based inflation expectations in the main advanced economies appears to be explained - at least partially - by the loss of confidence in the CBs ability to further stimulate the aggregate demand and revive inflation without affecting the financial stability (via moral hazard and market distortions). A number of other arguments support the idea of impaired CBs credibility, which is shared by many practitioners. In the Fed’s case for example, such an argument is represented by the recent repeated failures of the central bank officials to align the market expectations regarding the future path of the monetary policy key interest rate with the dots projections of the Federal Open Market Committee (FOMC). The apparent inability of the major CBs to lead the markets instead of following them is probably the main concern for these institutions nowadays - as Marvin King, the former governor of the Bank of England, emphasized in a speech held in 2005, “the real influence of monetary policy is less the effect of any individual monthly decision on interest rates and more the ability of the framework of policy to condition inflation expectations”.  Episodes of high market volatility and risk-off mood that followed some recent CBs announcements and decisions also support the idea of central bank credibility loss. The financial market developments that took place at the beginning of 2016 after the Fed December 2015 decision to raise the target range for the Federal Funds Rate for the first time after nine years represent a relevant example – the market participants challenged not only the decision itself but also the Fed economic projections and forward guidance.

Over the last years, more inconsistencies between monetary policy signals/pre-commitments and subsequent actions were observed - for example, at the end of January 2016, BoJ imposed a negative interest rate of minus 10 basis points to the “Policy Rate Balances” held by financial institutions in their current accounts with the CB soon after top officials of the bank claimed quite firmly that such a measure is out of discussion. This sort of inconsistencies could also be seen as an important red flag as regards the major CBs credibility[2].

Impaired credibility of G4 CBs, a hypothesis validated by the survey respondents

Not only the recent financial market developments support the idea of impaired CBs credibility, but also the results of the survey I conducted among market practitioners[3]. Approximately 80% of the respondents (49 out of 62) stated that - in their view - the credibility of the G4 central banks (Fed, ECB, BoE and BoJ) has been impaired in the last years.

But which are the relevant factors in assessing the level of central bank credibility? And how important is each of them?

I pointed out eight factors that might be relevant for evaluating central bank credibility. The surveyed practitioners were asked to rate the importance of each of these factors in explaining the (apparently) lower credibility of the G4 CBs[4]. The same scale was used for each factor, with the following five categories: “not applicable”, “not a relevant factor”, “not that important”, “important”, and “very important”. In order to rank the importance of the eight potential contributors to the loss of CBs credibility, I combined the first two categories into a single one and I rated the resulted categories with the following scores: “not applicable or not a relevant factor” = 0, “not that important”=1, “important”=2, and “very important”=3. Then, mean scores were computed for each factor.

Based on this methodology, the reduced monetary policy effectiveness observed over the last years was perceived as the most important contributor to the loss of the G4 CBs credibility. The moral hazard and market distortions associated with the aggressive non-conventional monetary policy easing measures adopted post crisis represented the second most important contributor, followed by the inconsistencies between monetary policy signals/pre-commitments and subsequent actions.

The following table presents the ranking of the (potential) explanatory factors for the (apparently) impaired G4 CBs credibility[5]:

The relevance and applicability of each factor for assessing the level of central bank credibility was validated by the vast majority of the relevant respondents.

It is worth mentioning that 95% of the survey respondents agreed that it is more challenging for the major central banks to achieve effectively their stated monetary policy objectives post crisis. I treated this answer as an acknowledgment of the respondents that in a more complex and uncertain economic and financial landscape, correctly assessing the reality and systematically adopting the optimal decisions has been a more difficult task for central banks. As a consequence, I assumed that the degree of exigency applied by the surveyed practitioners for assessing the CBs judgment, decisions, communication (including forward guidance) and monetary policy effectiveness was reduced accordingly.

The Bank of Japan was perceived as the least credible institution among the G4 CBs (by 41 out of 57 respondents), while the Fed was perceived as the most credible one (by 33 out of 59 respondents). These results are consistent with the most important contributor to the loss of CBs credibility pointed out by the survey respondents: the reduced monetary policy effectiveness. Interestingly, one economist that indicated the ECB as being the most credible institution among the G4 CBs stated that “the ECB is more <Fedish>i.e. credible since Draghi came in while the Fed looks increasingly <ECBish> since Yellen came in i.e. less credible”. He suggested that this was the decisive factor in determining which of the two CBs is the most credible in his opinion. I agree that the views, preferences, and behavioral profile of the CBs governors can affect significantly the credibility of monetary authorities. Rogoff (1985) suggested that the credibility of a CB is influenced by the commitment of the monetary authority head to fight against inflation by showing that society prefers governors who “place a «too large» weight on inflation-rate stabilization relative to employment stabilization”.

But what are the implications of the impaired CBs credibility on the asset allocation decision-making of the conservative investors?

In essence, the level of central bank credibility affects the asset allocation decision-making mainly via its impact on the market perception related to the monetary policy framework effectiveness. Therefore, before offering a perspective on the above mentioned question, I will present briefly the role of monetary policy stance within the asset allocation decision-making. Then, I will discuss the relevance and importance of CBs credibility regarding the asset allocation framework.

The role of monetary policy stance in the asset allocation decision-making

In a standard framework, in order to achieve their monetary policy objectives, CBs affect the dynamics of short term interest rates. Through their decisions and signals, monetary authorities also impact the broader financial market conditions and the degree of confidence among individuals. These in turn influence consumption, saving and investment decisions and further on the GDP and inflation dynamics. In my opinion, over the last years, the ultimate goal - and the biggest challenge in the same time - for monetary authorities has been to restore the strongly affected sentiment among investors and consumers.

Prevailing and expected monetary policy stance affects significantly financial market developments - at least in the short-run - through various channels. Over the last decades, the conventional main monetary policy instrument has been represented by the key interest rates. By affecting the official interest rates and offering signals regarding the future course of these rates (including via forward guidance), CBs influence (i) the money-market interest rates, (ii) the expectations regarding the future path of the official interest rates and, indirectly, the medium and long-term interest rates, (iii) the market-based inflation expectations and inflation premiums, and (iv) the market participants sentiment and risk taking behavior.

Following the Great Financial Crisis, the economic and financial landscape suffered major changes, some of them structural by nature. CBs had to adapt. They had to address unconventional challenges with unconventional solutions. After bringing the official rates close to the zero lower bound, a wide range of unprecedented (both by nature and scale) non-standard monetary policy measures was deployed in order to address the market disruptions, repair the transmission mechanism of monetary policy and stimulate the aggregate demand – various and massive asset purchases programs, ample unconventional refinancing operations, negative interest rates, and forward guidance. Asset purchases programs and unconventional longer term refinancing operations affect directly, and sometimes more effectively, medium and long-term yields and risk premiums in the fixed income markets. They also have a direct influence over the market-based inflation expectations as well as the market participants risk taking behavior.

Indirectly, via the above mentioned channels, CBs affect the domestic exchange rates, credit and liquidity premiums and non-fixed-income asset prices (stocks, gold etc.).

At the same time and in a more subtle way, the monetary policy stance affects indirectly financial market developments via its influence on the economic activity.

Due to its significant impact on the financial market developments, the monetary policy stance – current and expected in the foreseeable future – has a pivotal role in the asset allocation decision-making, both at a strategic and tactical layer. Differences in the monetary policy cycles of the relevant central banks are also essential, especially for multicurrency portfolio management. Currency composition, allocation among asset classes or securities issuers, and decisions regarding benchmarks, duration of the fixed income portfolios or risk limits and exposures are all dependent on the monetary policy stance (current and expected in the foreseeable future).

I will now turn to the last questions I address in the context of this paper: Is the level of central bank credibility a relevant input within the asset allocation decision making? How important is it? And what are the implications of the impaired CBs credibility on the asset allocation decision-making of the conservative investors?

The relevance and importance of central bank credibility for the asset allocation decision-making

In essence, the level of central bank credibility affects the asset allocation decisions mainly via its impact on the market perception related to the monetary policy framework effectiveness (judgment, decisions, communication, and the efficiency of market expectations management). This influence can be exercised through a number of channels.

Firstly, the level of central bank credibility affects the degree of monetary policy predictability and the market expectations formation process regarding the future stance of monetary policy. When credibility is impaired the monetary policy signals are treated with more reticence and less weight is attributed to them by the market participants. The degree of CBs decisions predictability becomes lower. In such an environment, like the one that prevails now, the divergences between market expectations regarding the future monetary policy stance and central banks forward guidance can be more salient than usual and prolonged.

The level of central bank credibility also influences the expectations regarding the market reactions (and the actual market reactions) associated to various monetary policy signals and decisions. Finally, in certain circumstances, the level of central bank credibility affects the investors risk-taking behavior as well as the financial market volatilities and correlations. When CBs lack credibility it is more probable to observe episodes of counterintuitive market reactions, high assets volatility and risk off mood after monetary policy signals and decisions that differ (markedly) from the market expectations. For example, despite the relatively hawkish message delivered on 21^st of September by Janet Yellen - the Fed president - after the FOMC meeting, the yields quoted for the Treasury notes and bonds decreased in the following two days[6] within all the maturity buckets. From the end of 20^th of September until the end of 23^rd of September 2016, the implied cumulative probability associated with an increase of the target range of the Fed Funds Rate until December 2016 dropped by almost 3 percentage points (Source: Bloomberg calculation based on the Fed Funds futures quotes). In my view, these counterintuitive market developments can be explained – at least partially – by the impaired confidence in (i) the Fed ability to accurately assess the economic and financial outlook, and balance of risks or (ii) in the relative importance attributed by the central bank to the economic and financial variables (domestic and external) within the monetary policy decision-making.

Through the above mention channels, I believe that the level of central bank credibility is both relevant and important for the (strategic and tactical) asset allocation decision-making. The survey respondents agreed with this view. The level of the CBs credibility was perceived as being a relevant input for the asset allocation decision-making by all the respondents (62 out of 62 respondents). At the same time, it was considered not only a relevant but also an important or a very important input by almost three quarters of the respondents – half of them saw it as being important, while almost a quarter saw it as very important. The scale used to rate the importance of CBs credibility for asset allocation decisions consisted in the following four categories: “not a relevant factor”, “not that important”, “important”, and “very important”. One of the surveyed strategists stated that if a central bank convinces the market that in a certain monetary policy cycle adopted the right measures, the market will follow it in the next one. The respondent viewed the level of CBs credibility as an “important” input within the asset allocation decision-making.

Overall, the survey results confirmed that the level of central bank credibility is both relevant and important for the asset allocation decision-making.

But what are the implications of the impaired CBs credibility on the asset allocation decision-making of conservative investors? The next and final section of this paper addresses this question.

The implications of the impaired CBs credibility on the asset allocation decision-making of the conservative investors

The current economic, financial and geopolitical global environment is more complex and challenging than ever in the post World War II era. The unconventional and highly expansionary monetary policy conduct that prevails in the advanced economies and the impaired CBs credibility distort the traditional correlations between economic fundamentals and financial assets prices, as well as the correlations among different financial markets. The episodes of high volatility and abrupt changes in assets prices further complicate the asset allocation decision-making.

Paradoxically, individuals tend to rely even more - in their investment decisions - on quantitative models and technical factors in the detriment of qualitative judgment, fundamentals and common sense. At the same time, behavioral biases appear to play a significant role within the asset allocation process. In such an environment, it is much more difficult to predict the investors behavior and the financial market developments.

It’s a new era both for monetary policy and portfolio management[7].

In my view, in this new era, the lower level of CBs credibility might affect – currently and in the foreseeable future - the asset allocation decision-making for conservative investors (such as international reserves managers, sovereign funds, pension funds or insurance companies) in a number of ways, such as follows:

• More diversified strategic asset allocations as well as shorter investment horizons and/or more frequent revisions of the strategic asset allocations due to higher uncertainty regarding the future monetary policy course.
• A lower weight attributed to the monetary policy signals and forward guidance in the detriment of the market consensus regarding the future monetary policy course – in a less credible monetary policy framework, CBs tend to be more sensitive to the market sentiment and expectations; as a consequence, the monetary policy decisions tend to be more market driven than usual.
• A somehow lower strategic weight attributed to inflation linked bonds than would otherwise be considered as optimal - ceteris paribus, in a less credible monetary policy framework, it is more difficult for CBs to raise the market-based inflation expectations and inflation rates, therefore the attractiveness of the inflation linked fixed-income securities relative to comparable conventional bonds is affected; on the other hand, the inflation premiums[8] might increase more due to the higher uncertainty regarding the future monetary policy path which in turn could affect positively the investors perception regarding the relative attractiveness of the inflation linked bonds (a rise in volatility could also determine an increase in inflation premiums).
• A higher strategic overall duration for fixed income (sub) portfolios than would otherwise be considered as optimal, with a bias towards a bullet strategy instead of a barbell one[9] – ceteris paribus, in a less credible monetary policy framework, keeping real interest rates lower for longer by the CBs in order to revive the aggregate demand and inflation expectations appears to be warranted.
• A higher strategic weight for gold – in a highly expansionary monetary policy environment within the advanced economies (massive excess liquidity and extremely low, even negative, interest rates), the impaired CBs credibility affects the confidence in fiat currency and increases worries regarding financial stability which in turn makes gold (which is perceived by many market practitioners as the natural alternative to fiat currency and the ultimate safe-haven asset) even more attractive; gold would outperform if certain risks materialize while offering diversification benefits to the overall portfolios.
• Tactical over allocation to safe and liquid assets in periods of high volatility due to a lower confidence in CBs ability to intervene effectively in order to calm down the markets.
• Tactical over allocation to safe and liquid assets should CBs adopt monetary policy decisions that differ markedly from the market expectations – for example, if Fed is perceived to be too aggressive in its interest rate hiking cycle, risk off mood could swiftly install in the markets.
• A more dynamic and opportunistic approach with respect to fixed-income securities (both conventional bonds and floating rate notes) meant to exploit perceived market mispricing of such instruments - in a less credible monetary policy framework, the divergences between market expectations regarding the future path of monetary policy rates and central banks forward guidance can be more salient than usual (but also prolonged).

Conclusions

Considering the financial market developments in the context of the recent G4 CBs announcements and decisions as well as the survey results, it’s reasonable to conclude that some credibility loss occurred over the last years for all of the examined central banks, unevenly and most significantly for BoJ. The survey results also confirmed that the level of central bank credibility is not only a relevant input but also an important one within the asset allocation decision-making. This conclusion got more consistency after I emphasized the three channels through which – in my view - the level of CBs credibility feeds into the asset allocation framework.

I believe that the impaired CBs credibility will continue to affect the market sentiment in the foreseeable future. This in turn will temper the investors “hunt for yield” observed over the last years in the context of the highly expansionary monetary policy stance adopted in the advanced economies (conservative investors tended to increase their exposure to riskier assets also). In an impaired monetary policy framework, a somehow more prudent and flexible risk taking approach will probably be adopted by conservative investors in the following years (ceteris paribus). More focus will be placed on risk diversification at a strategic layer, while the general tactical approach will probably be more dynamic and opportunistic than usual.

Appendix

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