Short on tools, central banks left with words

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Some of the world's most prominent central bankers may have to hope the pen is as mighty as the sword.

With the Federal Reserve, the European Central Bank and other authorities in industrialised countries already stretching the limits of monetary policy, pressure has risen for them not go any further, and even to begin pulling back.

Top officials have had to rely increasingly on speeches - not always successfully - to convey to financial markets how they intend to manage their economies.

"A new policy regime characterised by jawboning is now here," said Eric Green, economist at TD Securities. "Policy is more constrained and more accommodation increasingly problematic in scope and complexity."

As U.S. Treasury yields began to rise in late March on signs of an economic recovery, Fed chairman Ben Bernanke gave a speech that focused on the weakness of the labour market.

Stocks and bond markets rallied on hopes that this meant he was gearing up for a third round of quantitative easing or QE3.

The following week, the release of minutes from the Fed's March meeting painted a much more hawkish picture, with a dwindling number of voting members on the Federal Open Market Committee - just two of 10 - actively considering more stimulus.

The news prompted Vincent Reinhart, a former Fed staffer now at Morgan Stanley, to sharply revise down his forecast for the prospects of QE3 to just 1/3 from 2/3.

Then, just a few days later, data showed the pace of job creation halved in March from previous months, reviving some of the bets on more Fed action. However, economists said policy-makers would not read too much into one's month data.

"This transparency thing is completely new to the Fed. They are making it up as they go along, and they're confusing people," said Steve Wyatt, a professor of finance at Miami University's Farmer School of Business.

A string of Fed officials, including Bernanke, will speak at public appearances this week - so investors could be in for another rollercoaster.

It's not just in the United States that the effort to talk down rising interest rates is taking hold.

In the euro zone, the European Central Bank's injection of more than 1 trillion euros in loans to banks seems to be as much additional support the region's recession-threatened economy can hope for.

But ECB President Mario Draghi has made clear he will not be pressured into tightening monetary policy quickly.

While at pains to assuage concerns among a German-led group of ECB policymakers about inflation, Draghi dismissed a Bundesbank push to begin preparing to reverse course.

"Any exit strategy talking for the time being is premature," he said, adding bluntly: "I think the president of the ECB is the one who has the last word on this."

Unless the global economy suffers a new shock, such as a sharp slowdown in China, policymakers may have to rely on providing verbal guidance to markets rather than resort to another round of measures such as bond purchases or loans to banks to boost liquidity.

Even the governor of a central bank that does look set to ease further, the Bank of Japan, has warned that an over reliance on bond purchases might be interpreted by financial markets as a backdoor government bailout.

Jaime Caruana, general manager of the Bank for International Settlements, echoes concerns that governments are being allowed to put off the pain of fixing their balance sheets.

"There is a serious risk of overburdening monetary policy," he said at a recent Fed conference in Washington.

In the United States, the approach of November's elections could make it harder for the Fed to act even if internal support for easing were to gather momentum. Republican candidates have openly accused Bernanke of risking an increase in inflation and jeopardizing the dollar.

Chicago Fed President Charles Evans, one of the Fed's most dovish officials, argues the central bank could squeeze more stimulus from its recent guidance that interest rates are likely to stay low until at least late 2014 if it conveyed to markets that this was more of a firm promise than just a forecast.

Others, like James Bullard of the St. Louis Fed, take the exact opposite view: "The 2014 language in effect names a date far in the future at which macroeconomic conditions are still expected to be exceptionally poor. This is an unwarranted pessimistic signal for the (Fed) to send."

The other issue is, will the markets believe the Fed's low rates guidance? And if not, does the central bank risk a loss of credibility? Wyatt of Miami University sees this as a big concern.

"They're going to have a heck of a time with that. You're seeing pretty strong evidence that the market is pricing in a move sooner, despite what the Fed says."