Central bank communication has changed a lot over the years. It used to be shrouded in mystery, but over the past decade there has been an increasing appreciation of the importance of managing expectations as a way to smooth financial and economic volatility.
Federal Reserve Chairman Ben Bernanke spoke eloquently on the importance of central bank communication yesterday.
“The public’s expectations about future monetary policy actions matter today because those expectations have important effects on current financial conditions, which in turn affect output, employment, and inflation over time,” Bernanke said. “Indeed, expectations matter so much that a central bank may be able to help make policy more effective by working to shape those expectations.”
Central banks across the world communicate in different ways and have different degrees of transparency and accountability. The Reserve Bank utilises Board minutes, quarterly reports and public speeches to manage expectations. The Federal Reserve uses many of the same tools, but their communication has also become more explicit – while simultaneously being perceived as less transparent – after they dived into the murky waters surrounding forward guidance.
With forward guidance, the Fed shifted their communication away from a qualitative goal – they stated they would not raise the cash rate until 2012, which became late 2014 and then mid-2015 – to a more quantitative goal. Now they will consider raising rates once the unemployment rate hits a 6.5 per cent threshold. This shift in communication policy has been met with some confusion by the markets. Similar confusion has been felt in the United Kingdom and Europe.
Most of the confusion surrounds the distinction between thresholds and triggers. If forward guidance offers a trigger, then it creates an impetus to act, whereas as a threshold it denotes an intention to consider acting. Bernanke said as much during his speech yesterday.
“As my colleagues and I have frequently emphasised, the conditions stated in this guidance are thresholds, not triggers. Crossing one of the thresholds will not automatically give rise to an increase in the federal funds rate target. Instead, it will signal only that it is appropriate for the Committee to begin considering whether an increase in the target is warranted,” Bernanke said.
It strikes me as strange that there was and remains so much confusion surrounding forward guidance, though that could be my inner central banker speaking. Generally, central banks are haunted by indecision; that’s not necessarily a criticism of central banks as much as it is the very nature of economists. Put enough of them in the room and you will get a lot of indecision.
Once you recognise this, it becomes obvious that no credible central bank will set itself a policy objective without at least some wiggle room. The Fed believes they will not have to change policy until unemployment hits 6.5 per cent, but they were never going to lock themselves in to a fixed decision. Nor was the Bank of England when it outlined its forward guidance policy – on the condition that inflation expectations remain anchored and a recovery looks sustainable.
I don’t blame the Bank of England for applying conditions to its forward guidance objectives. From the perspective of a central bank, flexible policy is preferable to fixed policy. But ironically, what constitutes good monetary policy may also – in the case of forward guidance – compromise the credibility of the central bank. The markets’ interpretation of forward guidance means that a conditional policy lacks credibility as a guidance tool.
According to a recent Reuters poll, a small majority of economists surveyed in the UK believe that the Bank of England’s handling of forward guidance has eroded its credibility. Credibility is important given it directly affects the public's interpretation of central bank communication and the resulting expectations. Perhaps the communication surrounding forward guidance will improve as the policy becomes more well-known.
Luckily for Australia, we have not had to worry about forward guidance, although the Reserve Bank frequently manages expectations. Based on my experience at the Reserve Bank, the publics’ interpretation of Reserve Bank communication is generally fairly accurate, although far too much time is spent trying to read between the lines for hidden insight that isn’t there.
Although the Reserve Bank’s communication is clouded with uncertainties and upside and downside risks, the public typically believes what the Reserve Bank says. Whether you agree with their policy stance or not, the market believes the Reserve Bank will contain inflation and promote growth. The credibility afforded to the Reserve Bank is often taken for granted, but the forward guidance mess has really reinforced to me the importance of central bank communications, expectations and the credibility required to make it all work.