Central banks’ policymaking under uncertainty

This is a question we dare say that all central banks are asking themselves right now given that uncertainty is very high; on some measures on a par with the uncertainty seen during the 2008 global financial crisis or the pandemic in 2020. Slowly, but surely central banks are developing the answers to this question – and they are answers that could keep financial markets on their toes.

In the Standard Bank’s view, the fashion within developed-country central banks is for scenario analysis. Rather than establish a base, or central view amongst its members, and examine the risks around this central case, there seems to be a growing desire to formally elucidate alternative scenarios that the central bank can quickly jump to as economic conditions change.

In the UK, for instance, one of former Fed Chair Bernanke’s recommendations in last year’s review of BoE policymaking was that the bank should consider this sort of scenario analysis, and it looks as if BoE members are keen to action this recommendation. But in addition to a longer-term structural change in central bank policymaking towards some sort of scenario analysis it is increasingly clear that some short-term scenario differentiation is called for as well given the uncertainty created by the new US Administration.

Bank of Canada Governor Macklem admitted as much in a speech last week although Canada, along with Mexico lies in the eye of this US storm more than others given the very high tariffs that Trump is threatening to impose on the country next month. But will these tariffs actually be introduced? And, if they are, will they lift inflation more than they hurt growth, or vice versa? So, straight away we can see a number of scenarios here that perhaps have a pretty similar probability of happening.

It means that the BoC can’t just go with a base case that might, for instance, assume permanent tariffs that cause growth to slump while having a negligible bearing on inflation. Or a base case in which tariffs are put on and taken off with little cost to growth but a high cost to inflation given all the uncertainty. The Bank risks making a huge mistake if it adopts any one of these as its central case and then sets policy in a way that concurs with only this scenario.

Instead, the best approach, as Macklem hinted is to adopt a policy that tries to take into account alternative scenarios. Now this is not easy. It means that rather than aggressively pursuing a policy based on a single base case the central bank needs to set policy that “minimizes the risk” given the near-equal probability of these alternative scenarios. Right now, that probably means doing nothing as banks try to get clarity on whether US policy is more likely to lift inflation, depress growth, or both. That might mean a policy pause for many. However, as Macklem also suggested in his speech, the Bank may have to act quickly when the uncertainty clears.

In short, the Bank has to respond to the here and now, not to what it forecasts about the future. If the situation is difficult for central banks, it is also difficult for those in financial markets as they try to second-guess what the central banks will do. Central bank forecasts, such as the Fed’s so-called DOTs plot of fed funds forecasts by members of the FOMC cannot be expected to be as accurate when uncertainty is high and alternative scenarios seem to have broadly equal weights.

Perhaps fortunately, most developed-country central banks have made some significant adjustments to policy already with steep rate cuts, and few more than the Bank of Canada. In short, things might be a little easier for those banks who have policy in a broadly neutral position. But for others, like the Bank of England, that still seem some distance from neutral, high global uncertainty increases the risk of a policy mistake even if alternative scenarios are considered.