Memo To The ECB: Policy Commitments Matter More Than Purchases

The word on the street today is that the European Central Bank is making big bond purchases today in an effort to reverse — or at least contain — the bond market chaos unleashed yesterday by the Bundesbank. It doesn’t seem to be working.

This should come as no surprise to anyone. Central bankers around the world seem to repeatedly fail to grasp that their most important power is the ability to set expectations. Ordinary market participants impact prices by buying and selling things. But central banks have a unique capacity to buy and sell certain classes of things in essentially unlimited quantities. That means they can move prices by simply threatening to buy and sell things. This is how the Federal Reserve conducts “normal” monetary policy operations. It sets a target for short-term interest rates and, sure, does a bit of buying or selling to move the market toward the target. But the real work is done by the target, not by the purchases. Everyone knows that the Fed is committed to doing what it takes to hit the target, so markets naturally move toward the target. The Swiss central bank did something similar recently with its currency. It said that it would intervene in the foreign exchange markets and it would keep intervening until the Swiss Franc got below a certain target. Then they did a bit of intervening. But just a bit. Markets move on their own in anticipation of the target.

If the ECB wants to cap Italian interest rates that’s what it needs to do. State clearly and concisely what the target is. There’s an old saying about how you shouldn’t pick a fight with someone who buys ink by the barrel. By the same token, it would be absurd to gamble in Euro-denominated asset markets against an institution capable of printing Euros in unlimited quantities. But if they insist on intervening without setting a target, they’re going to fail to achieve their goals and simultaneously discredit themselves in the public eye.