Forward Guidance: Should the SNB have shocked the world?

There has been a very public divergence in central bank practice this week.

For six months, the European Central Bank (ECB) has been slowly building towards an expected announcement implementing Quantitative Easing (QE) in the Eurozone. Carefully tailored releases and winks have unsubtly alerted the markets that QE was coming to Europe and that market actors better be prepared.

By contrast, the Swiss National Bank (SNB) shocked the markets with a surprise announcement that it would be both abandoning their 3 year-old currency peg to the Euro and cutting interest rates. The effects have been likened to a future “nuclear explosion” [Logutenkova & Vögel; 2014], with immediate impacts including a 41% increase in the Swiss Franc against the Euro and a 20% decrease in Credit Suisse’s stock price.

Whilst it is clear that the policies themselves are debatable, the issue to be discussed here is not centred on evaluating economy management strategies.

Rather this week has highlighted a broader question: what is the best style for central banks to take action? Should banks use a long lead-up time to corral market agents into calmly closing arbitrage opportunities and perhaps suffer a reduced impact of their actions? Or should they hide their planning and shock economies into a given direction and risk volatilit and credibility?

This piece shall first explore what is the currently recommended practice and critique it. Subsequently we will look into the merits of the alternatives and attempt to highlight the best approach.

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Critiquing “Orthodox” Central Banking

Modern mainstream economic recommendations for central banking encourage a strict monetary policy remit of singularly managing inflation through the policy interest rate. [e.g. Woodford; 2004] The justification for this position mainly arises from New Consensus Economic’s abstract micro-foundations methodology and the practical inhibitor of the Lucas Critique. By complying with this simplified framework, orthodox central bankers believe their modern practices have a supposed universality of applicability that defends their narrow intentions and renders creative thought unnecessary .

Yet, even a simple analysis of the methodological idiosyncrasies of the mainstream practice immediately expose the limitations of its recommendations. Furthermore once heterodox economic opinions are introduced to recount theoretical oversights and contrasting suggested practices, it becomes apparent that the supreme universality claimed by the orthodoxy collapses. Additionally, political economy evidence of monetary policy from central banks around the world illustrate the feasibility and greater beneficial capacity of contrary practices – especially for developing nations and during times of economic stress.

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