The power of words

From ancient Greek rhetoricians to the modern-day everyman, words and the art of expression have been used for millennia as the precursor to communication. They have also shaped history.

Words or phrases have in many cases been used directly following significant events. Be it Archimedes, Napoleon or Armstrong, great feats of human history are –through expressions and quotes– encapsulated in time immemorial.

Words have also worked as the impetus for crucial milestones. The fall of the Berlin Wall materialised due to a botched announcement or careless remark by an East German official, whilst Rosa Parks thrusted the civil rights movement into action by simply refusing to give up her seat.

Central bankers around the world have taken a special interest in the latter way of using words; i.e. using communication to galvanise or guide action. This monetary policy tidbit, frequently found in a secluded paragraph of any macroeconomics textbook, is commonly known as forward guidance – once a taboo practice, now part of any good central banker’s toolkit.

Former Fed chair Ben S. Bernanke highlights in his book 21st Century Monetary Policy (2022) how hinting, whether implicitly or explicitly, future economic prospects and policy decisions began finding support amongst policymakers around the early 2000s. This practice sought to improve policy transparency thereby increasing people’s confidence in the central bank – a credible and trusted central bank is the prerequisite for a successful central bank, after all. Furthermore, aligning market expectations with policymakers eliminates friction in the transmission of monetary policy.

To understand how powerful words can be, think of the following. Say, for instance, a country is experiencing stagnant growth due to uncertainty in future economic prospects. A central bank may decide to put out an announcement ensuring people that policy rates will be low in the near future and that monetary policy will be accommodative: as a result, people will be more confident to take out loans and to consume, resulting in an uptick in growth.

However, with great power comes great responsibility. Just as forward guidance can help improve transparency and confidence, it can result in unintended consequences: if a CB were to suggest that interest rates will be raised in the near future to combat inflation, the result may be a sporadic increase in consumption whilst interest rates are still relatively low, hence exacerbating demand-pull inflation.

Perhaps the most profound example of the power of words for central banks came in the aftermath of the European sovereign debt crisis. High levels of public indebtedness following the global financial crisis reached a critical threshold around 2010 when Spain, Ireland, Portugal, Greece and Italy found it near impossible to refinance their maturing debt obligations; market uncertainty and economic turmoil had pushed sovereign bond yields to a level where many countries were facing default.

A “bankrupt” Greece or Italy would have marked the end of the budding euro and the mere decade-old monetary union. In the eve of the unparalleled financial disaster, the European Central Bank devised an emergency policy tool that would allow it to purchase eurozone sovereign bonds (in the secondary market). By engaging in outright monetary transactions (OMTs), the ECB presented itself as the lender of last resort to sinking countries. And yet, the ECB never lent out anything through this programme.

As of time of writing, Italy and Greece are still healthy members of the eurozone. So, what happened? As it would turn out, words proved to be the missing puzzle piece to stop the unmitigated and seemingly unavoidable crisis. In July of 2012, the ECB’s then president Mario Draghi addressed the situation, stating that “the euro is irreversible” and that “the ECB is ready to do whatever it takes to preserve the euro.” The three words whatever it takes (backed by the threat of OMTs) would mark an inflection point in the crisis, turning the tide and cementing market confidence in that the ECB, indeed, was ready to do whatever it took to avoid a catastrophe.

Words, used correctly, are an unstoppable force. Through words communication and trade take place, empires rise and fall, revolutions occur and key elements of human history and culture are forever remembered. They are also an invaluable tool for policymakers.

As the European sovereign debt crisis was subsiding in late 2013, a member of the ECB’s executive board reminded markets that “OMTs are not just words: the ECB is fully prepared to use them.” The solution may not just be words. But sometimes, just words are enough.