08 May 2012

Bank of Ireland Governor, Patrick Honohan: The return of the surprise in central banking

In his speech at the OMFIF Golden Series on World Money, Mr Honohan said that some of the great pivotal moments in the history of central banking were about shock tactics, the timing, their potential impact and the communications around them. He presented three key lessons to be kept in mind.

Three lessons:

1. Timing is everything: when it comes to such surprises, timing can be everything – better not be late. There may be no second chances; missing the moment for the decisive surprise intervention may place you in a very bad position.
2. Long-lasting effects: surprise announcements can have long-run effects.
3. Credibility and truthfulness: central-banking-by-surprise makes candid communication extremely difficult. Yet we all agree that credible communication is essential for lasting policy success: so this is a problem with fixed but adjustable exchange rate regimes, for example.

Let’s think of the two major recent ECB policy surprises: the SMP in May 2010 and the three-year LTROs in December 2011. How do we rate them considering the lessons that have been proposed above?

The SMP announcement occurred at a time of great market tension. Sovereign risk contagion from Greece had just begun, and there was the additional background of the unnerving flash crash. The danger that sovereign spreads would spiral away, undermining monetary transmission as well as a lot of other things, seemed real, especially as the funding firewall that was quickly agreed at political level would take several months to become a reality. ECB intervention in secondary debt markets looked like a sensible and urgent action needed to nip things in the bud. The action was prompt and the spike of yields was removed (cf lesson 1). And what about the longer run? Well there have been consequences, but not those imagined at the outset. Sovereign spreads widened again and, though the programme was used again with varying degrees of vigour, it cannot be said by any means to have eliminated the cross-country variations which are indeed impeding the smooth functioning of the monetary transmission. And it has not avoided the large debt exchange at steep haircuts for Greece, the original biggest target of the programme. Lesson 3 is also confirmed. Communication around the SMP introduction, and the well-known differences of opinion which surrounded it, tended somewhat to undermine the coherence of communication by central bankers generally and was problematic. The jury is still out on whether the policy has been a lasting success, and there are of course different views on what it could have been expected to achieve long-term.

Let’s hope that the three-year LTRO, brought in once again in response to financial market pressures, not only on sovereign bonds, but especially on bank funding, does have the lasting effects that are so widely hoped for it. Certainly it was well-timed (lesson 1), though some observers will have hoped for this or more at an earlier stage, and can note that, despite its scale and duration, it has not brought, for example, Irish sovereign spreads below the levels that triggered the bailout in November 2010. Let’s hope that lesson 2 applies, and that it will be of lasting value. As for lesson 3, this time the measure seems to have been relatively trouble-free on the communications front.

The crisis has brought back centre stage the role of dramatic announcements with far-reaching effects. It is important to get the timing right: too late and a lot of damage can be done; too soon and the side-effects may be worse than the hoped-for effect (if the source of the problem has been exaggerated or misdiagnosed). And the communications issues are more challenging than the finely-honed practice of monthly announcements by inflation targeting central banks.

Full speech

© BIS - Bank for International Settlements