Latest / Monetary Policy Explained with Fexingo: Central Banks, Money Supply, and Interest Rates / How Central Banks Use the Expectations Channel
Transcript
- Lucas: Let me start with a number that broke the economics internet in 2016. The Bank of Japan set a target for the 10-year government bond yield at exactly zero percent. Not a range. Zero. Luna: And they didn't even buy enough bonds to enforce it. They just said, this is where it will be. Lucas: Exactly. That's the purest example of what we're talking about today — the expectations channel. Most people think central banks move the economy by changing the policy rate. Raise rates, borrowing gets more expensive, spending cools. That's the direct channel. But there's a whole other layer. Luna: Which is just, what everyone expects the central bank to do next. Lucas: Right. The expectations channel works because markets and households make decisions based on the future. If the Fed says, 'We're going to keep rates low for two years,' businesses might borrow and invest today, even if the current rate is already a bit higher. They trust the promise. Luna: But only if they trust the promise. That's the catch. Lucas: That's the whole game. The Bank of Japan's zero-percent target worked for a while because markets believed they had the tools and the will to defend it. They barely had to buy bonds. Just the announcement shaped yields. That's the expectations channel firing on all cylinders. Luna: Then in 2022, when global yields rose, they had to buy a ton of bonds to hold the line. The promise alone wasn't enough anymore. Lucas: Because credibility eroded. That's the flip side. The channel only works if the public believes the central bank will follow through. And credibility is built over decades, but can crack in weeks. Look at the Fed's forward guidance in 2022. Luna: You mean when they said inflation was transitory? Lucas: That's the famous example. But even after they pivoted to hawkish, they used the dot plot to signal higher rates. In June 2022, the median dot projected rates at 3.4 percent by year end. Markets priced it at 3.8 at one point. A 40-basis-point gap — that's a credibility gap. Luna: So the market didn't believe the central bank's own forecast. That's the channel breaking down. Lucas: Exactly. The academic foundation here comes from Michael Woodford's 2003 book 'Interest and Prices'. He argued that in modern economies, central banks don't control the economy through the current rate — they control it through the entire expected path of future rates. If you can shape expectations, you can move long-term yields without moving the short rate much. Luna: Which is why forward guidance became such a big deal after 2008. The Fed started saying not just where rates are, but where they'll be. Lucas: Date-based guidance first — 'rates will stay low through mid-2013.' Then state-contingent guidance — 'until unemployment falls below 6.5 percent.' Each iteration tries to make the promise more credible by tying it to observable conditions. Luna: And we're now in a world where the Fed barely does forward guidance at all. They've gone back to data dependence, which is almost the opposite — we won't tell you what we'll do, we'll react to what happens. Lucas: That's partly because the expectations channel got burned. In 2021, the Fed said inflation was transitory and markets believed them. Then inflation stayed. When the Fed later tried to guide rates higher, markets said, 'Prove it.' So the channel was damaged. Luna: You mentioned Woodford. Wasn't there a whole debate about the 'forward guidance puzzle'? Lucas: Yeah. Academic models predicted that extending the zero-rate period by one quarter should boost output massively — like, unrealistically. In reality, the effects were much smaller. That's the puzzle. Why doesn't forward guidance work as powerfully as theory suggests? Luna: Maybe because people are rational in a way models don't capture. They know the central bank might change its mind. Lucas: That's exactly it. The time inconsistency problem — Kydland and Prescott's Nobel-winning idea. A promise made today might not be optimal tomorrow. If the economy strengthens, the central bank has an incentive to break its promise and raise rates early. Everyone knows that, so they discount the promise. Luna: So the expectations channel depends on the central bank having a reputation for keeping promises, even when it hurts. Lucas: Which is why the European Central Bank's 'whatever it takes' moment in 2012 was so powerful. Draghi said the ECB would do 'whatever it takes to preserve the euro.' No rate change. No bond buying yet. Just words. And spreads collapsed. That's the expectations channel at its peak. Luna: Because people believed him. He had the institutional credibility and the backing. Lucas: He also had a credible threat — the Outright Monetary Transactions program was designed but never used. The mere existence shaped expectations. That's the channel working through what economists call the 'signaling channel,' a subset of expectations. Luna: Let me push on something. If the expectations channel is so powerful, why do central banks still change rates at all? Why not just talk? Lucas: Because talk without action eventually becomes cheap. The Bank of Japan learned that. In 2023, they had to widen the yield curve control band because markets kept testing them. Action reinforces the signal. You need both. Luna: Speaking of the show — we've talked a lot about how central banks communicate, and I think that's part of why listeners stick with us. We try to make this stuff clear without dumbing it down. Lucas: Yeah, and we deliberately don't run ads on these episodes. Not because we don't need the money, but because we think the conversation flows better without interruptions. If that approach resonates with you, and you want to support it, the link is buy me a coffee dot com slash fexingo. No pressure, just an option. Luna: Exactly. A listener told me last week that our episode on the reverse repo facility finally made the plumbing click. That kind of feedback means a lot. Lucas: Alright, back to the expectations channel. Let's talk about the Bank of England's experience in 2022. They issued forward guidance in August that rates would need to rise 'significantly' — but they didn't specify how much. Markets went haywire. Luna: Because the guidance was too vague. Vague guidance can actually increase uncertainty. Lucas: Precisely. Research by the BIS found that vague forward guidance can increase the volatility of market rates. The channel requires precision to work. The Fed's dot plot, for all its flaws, at least gives numbers. The BOE's qualitative guidance backfired. Luna: What about the Reserve Bank of New Zealand? They've been using a published rate track for years — actual numeric projections of the policy rate. That's the most explicit form. Lucas: And it seemed to work well. Markets anchored to those projections. But then in 2021, the RBNZ had to revise them sharply upward when inflation surprised. That hurt credibility too. No central bank has perfect foresight. Luna: So the expectations channel is fragile. It's powerful when credibility is high, but once damaged, it takes time to rebuild. Lucas: That's the key insight. Central banks spend enormous effort guarding their credibility precisely because the expectations channel is their most potent tool. A 25-basis-point rate move is nothing compared to shifting the entire expected path of rates by 50 basis points through a well-crafted statement. Luna: Which is why Fed watchers parse every word of the statement. The 'considerable time' language in 2013, the 'patient' language in 2015 — those tiny phrases moved markets more than the actual rate decisions sometimes. Lucas: And that's the expectations channel in action. Woodford would say that's exactly how monetary policy works in a modern economy. It's not the rate — it's the story about the future rate. Luna: So next time you hear a central banker say something carefully vague, you know they're trying to manage expectations. And you know why it matters. Lucas: And whether it works depends on whether you believe them. That's the uncomfortable truth at the heart of modern central banking.