Central Bank Communication over the Past 20 Years
By Sean Eio
At a recent symposium “Navigating the Decade Ahead: Implications for Monetary Policy” on the 27 Aug 2020, US Federal Reserve Chairman Jerome H. Powell spoke of the pivotal role of central bank communication in the conduct of monetary policy within the context of the “new normal” constructed in the decade since the Global Financial Crisis of 2008–09. “To address this new normal”, he said, “we are conducting a public review of our monetary policy strategy, tools and communications” — the first of its kind at the Fed — “…we are examining the monetary policy tools we have used both in calm times and in crisis, and we are asking whether we should expand our toolkit. In addition, we are looking at how we might improve the communication of our policy framework.” The new normal requires that central bankers reflect on the big questions of: what, how and when to communicate — in a way that is most complementary to the renewed policy framework of the central bank.
A brief history of Central Bank communication
Today, central banks communicate a great deal — and in different ways including via speeches, reports, press conferences, research papers, and increasingly even via social media such as Twitter, but it hasn’t always been this way. Conventional wisdom held that central bankers should communicate as little as possible — what Swedish economist Karl Brunner in 1981 called an “esoteric art” revealed by an “inherent impossibility to articulate its insights in explicit and intelligible words and sentences”. Former Fed Chairman Alan Greenspan called it “mumbling with great incoherence” — which led to the coining of ‘Fedspeak’, what Alan S. Blinder called “a turgid dialect of English” used by chairmen in making wordy, vague and ambiguous statements. Soon enough, Blinder, at the 1996 Lionel Robbins lectures at the London School of Economics and Political Science, first conjectured that “greater openness might actually improve the efficiency of monetary policy…by making itself more predictable to the markets, the central bank makes market reactions to monetary policy more predictable to itself, (making it possible) to do a better job of managing the economy. By 2003, Greenspan, then Chairman of the Fed, had been explicitly managing expectations with forecasts of the Federal Funds rate.
“Greenspeak” — what exactly is the forecast of GDP here?
“The members of the Board of Governors and the Reserve Bank presidents foresee an implicit strengthening of activity after the current rebalancing is over, although the central tendency of their individual forecasts for real GDP still shows a substantial slowdown, on balance, for the year as a whole.”
Alan Greenspan, Testimony from the Federal Reserve Board’s semiannual monetary policy report to the Congress before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate on February 13, 2001
Fast forward to today, in addition to the fact that communication and managing expectations is now standard fare in both academia and central banking circles, economists such as Nobel laureate Robert J. Shiller emphasise the fact that changing narratives itself can cause economic fluctuations, and that an inability to manage the spread of narratives could upset the central bank’s ability to achieve their mandates. Many economists have heeded this to include serious quantitative studies of changing popular narratives in their research, and to establish the importance of changing narratives in causing fluctuations. This revolution in thinking, to say the least, necessitated by the fact that nominal policy rates across the world cut close to their zero lower bound today, has enshrined central bank communication as a policy tool in its own right. Understanding its effects is therefore paramount.
A theory of central bank communication
Central bank communication is the provision of information by the central bank to the public regarding such matters as the objectives of monetary policy, the monetary policy strategy, the economic outlook, and the outlook for future policy decisions.
Central bank as the clearing house
In the first place, what gives weight to what the central bank says? How does what they say affect the financial markets, and the public’s expectations of inflation, and ultimately, economic performance? Fundamentally, the central bank, of course, holds the unique position within the economy of being the clearing house between banks through which payments are aggregated and settled, giving them monopoly over the supply of the unit of account (both physical and digital currencies), and therefore the interest rates on this unit of account. More precisely, commercial banks are required to hold deposits at the central bank — called ‘reserves’ — for which there is a spread between the cost of borrowing and the cost of depositing these reserves at the central bank. For more on the interest on reserves, what they are, and diagrammatic representations, see the society’s article on “The US Central Bank: The Federal Reserve”. The control over the interest rates on standing facilities are key to our understanding of the range of monetary policy tools available at the disposal of the central bank.
Long-term rates matter more than short-term overnight rates
The central bank exercises control over the overnight bank rate, variously called the ‘policy rate’ or ‘federal funds rate’ or ‘official cash rate’, and uses these to affect the economy (we are currently abstracting away from how they do so, eg. control over the interest rate spread on standing facilities). A lowering of the policy rate, for example, reduces the real interest rate in the economy, holding all things constant, thereby inducing consumption and investment by households and firms and boosting aggregate output. Yet, very few economic decisions actually hinge on the overnight bank rate — think a 10-year loan that a firm needs to finance the purchase of a piece of equipment. If that is coupled with the fact that there is an effective lower bound associated with overnight rates, the central bank’s policy room becomes restricted to its ability to influence market expectations about the future path of overnight interest rates — which it does through communication, or ‘forward guidance’. While it does not control the 10-year rate now, it will control it in ten years’ time — and therefore credible communication shifts markets today. This is normally captured by standard theories of term structure, where interest rates on longer-term instruments reflect the expected sequence of future overnight rates:
The variables in this equation can be embedded in aggregate demand and supply functions, where:
Lastly, introducing a central bank reaction function where the central bank reactions to changes in the rate of inflation according to set “rules”, eg. The Taylor Rule, we have:
Channels
While academia has established that central bank communication moves market interest rates at various maturities, it is not so clear how the central bank influences long-term interest rates, i.e. the channels through which these movements occur. Most commonly discussed is the ‘expectations channel’ or the ‘information effect’, whereby central bank communication changes expectations or cures uncertainty about long-run economic and market fundamentals directly by transmitting information about shocks to variables, such as the equilibrium real interest rate itself. In more recent times, another channel, the investor demand channel, has also been proposed, which argues that news about short-term policy expectations is propagated to longer-maturity bonds by the trading activity of yield-oriented investors. This argues that long-term rates change because there are shifts in its demand from investors. In particular, investors react to news affecting short-run expectations by trading longer-term debt, to maximise the yield in their portfolios. Decreases in short-rates induce them to switch to longer-maturity bonds, driving yields down through changes in term premium, and vice-versa.
Another channel that has been discussed recently is the uncertainty channel, advanced by Stephen Hansen, Michael McMahon and Matthew Tong (2019). In the uncertainty channel, central bank communication operates not by changing long-run expectations of economic conditions (as in the expectations channel), but by providing news on risk and uncertainty on economic conditions and thereby providing guidance on the perceived variance of those conditions, and generating changes in the long-run term premium.
To investigate the uncertainty channel in their paper, they make use of the Bank of England Inflation Reports from February 1998 through May 2015 which are published quarterly one week after the announcement of the Monetary Policy Committee policy decisions. They decompose the reports into a set of numeric and narrative signals. Numeric signals include inflation and GDP forecasts as well as their variances and skews, while the narrative signals were derived from the prose describing the current state of the economy, covering recent developments in the near-term outlook for financial conditions, demand, supply, costs and prices, and then the bank’s forecasts. Coding all the data, they use the 754,884 words gathered from all the reports to create summary word clouds for the most likely words used for different contexts. They find that those words that drive the 1-year spot rates appear to relate to current economic conditions, while the key topics for the five-year forward rate appear to relate to the forecasts and their uncertainty, and are less cyclical.
Their paper finds that the long-run market rate appears to react to more than just the standard information effect (i.e. changing long-run level expectations), or the indirect result of trading activity, and provides robust evidence in favour of the uncertainty channel as an important factor in explaining why long-run rates react to central bank communication (in this case, the BoE’s inflation report) through a term premium effect.
What makes central bank communication matter?
Central banks therefore are in a unique position to communicate their beliefs about long-run uncertainty in the pursuit of better macroeconomic outcomes. In particular, by taking into account the uncertainty channel as part of the central bank’s overall communication strategies, central banks can reduce the variance of forecasts performed by private agents. The real economy is constantly changing, and at any given point in time, asymmetric information exists between the public and the central bank (debunking the stationarity of AD, AS and the term structure equation). The central bank, in fact, is constantly receiving signals about the economy itself, and so learning by and about the central bank never ends. Ben Bernanke, chair of the Fed during the Great Recession, notes that “the number of contingencies to which policy might respond is effectively infinite and unforeseeable.” Central banks also might be believed to have superior information on the economic outlook of the economy, seeing as it devotes more resources to the study of the underlying state of the economy than the average private forecaster — and individual agents in the economy could very well even look to the central bank as part of their heuristic approach to understanding the state of the economy. In such a scenario, central bank communication and learning by private agents are inextricably tied — if a credible central bank says that its forecast of long-run average inflation is going to be 2%, agents revise their estimate of inflation, and it turns out that actual inflation turns out to be 2%. Such a situation opens up a clear opportunity for the central bank to improve economic performance by providing information on the short-run underlying state of the economy, and its long-run inflation objective. Such a channel may also become particularly important when the central bank is confronted with the lower bound on policy interest rates.
Optimal central bank communication
Is there a consensus then for what constitutes the ‘optimal’ degree of communication? In theory, there are no clear conclusions regarding the optimal level of transparency. Cukierman and Meltzer (1986) argue that some degree of opacity actually enhances the effectiveness of monetary policy — the central bank can exploit the short-run Philips curve tradeoff to push down unemployment while allowing some inflation. On the other hand, Sibert (2002) argues that this gives too much discretion to the central bank, generating more inflation bias, and therefore makes society worse off. Inflation bias is the difference between achieved inflation and the optimal level inflation which is caused by discretionary monetary policy.
We see that while greater transparency may ostensibly be a good thing, it is not always clear that communicating more is unquestionably good. For example, on the recent discussion of negative interest rates — floated because it was seen as a potential policy lever that could be used to stimulate the Covid-19-depressed economy — the Bank of England has been said to have given ‘mixed signals’ on its stance, with RBC Capital Markets complaining about “mixed messages”, and Nomura noting how the BoE changed their stance twice in just a space of a few months. Professor Silvana Tenreyro had first cited ‘encouraging evidence’ from Europe about the effectiveness of negative rates, but this later was contradicted by deputy governor Dave Ramsden in Sep 2020, who declared that the effective lower bound was 0.1% (at current levels). Central banks also seem to acknowledge that communication under certain circumstances can be undesirable — which is why most observe a blackout period before each policy meeting and other major announcements.
So, as The Economist posits, can central banks talk too much? Some argue that forward guidance on interest rates complicates price dynamics in the bond market as there is a significant level of simultaneity in the behaviour of the central bank and the financial markets — the central bank both signals its intentions to the markets, but also takes its cues from them. With regard to communicating to private agents, there is also a fear that there are limits to how much information can be digested effectively, and whether the public might fail to understand the uncertainty and the conditionality surrounding central bank forecasts. Moreover, the central bank might also wish to avoid the panic that would be induced when the public comes to realise actually how uncertain the central bank itself is about economic conditions.
We embark on a cursory survey of communication styles below.
The ‘what’, ‘why’ and ‘how’
Each of the three central banks have their own styles of communication, and we now examine the different types of signals that central banks send, concentrating mainly on three major central banks — the Federal Reserve System, the Bank of England, and the European Central Bank. Here is a summary of what differentiates these banks:
In general, central banks seek to communicate at least four different aspects of monetary policy:
(1) Overall objectives and strategy
Communication about overall objectives and strategy usually involve enunciating its mandate — sometimes in quantitative terms with numerical targets. In favour of the argument for quantifying central bank objectives, numerical targets facilitate accountability, providing a metric to assess the performance of the central bank. Secondly, the quantitative objective helps to anchor inflation expectations of economic agents, which then help to stabilise actual inflation.
(2) The motives behind a particular policy decision
Practices differ regarding what central banks should or should not say in the statement that accompanies a particular monetary policy decision — how much should be disclosed about the decision-making process? Should minutes be published? Should individual votes be published and allowed to be scrutinised, as the Bank of England’s Monetary Policy Committee does? These shape the environment….
(3) The economic outlook
When it comes to addressing the economic outlook, inflation targeters tend to be more explicit about their assessment of expected future inflation in periodic reports. For example, the Bank of England releases their periodic ‘fan charts’. The ECB, with no explicit inflation target, now publishes their staff projections four times a year, while the Fed keeps staff projections secret but publishes FOMC forecasts of inflation four times a year. In terms of economic growth, most central banks provide official forecasts of output measures, though none of the three central banks in question are explicit about estimates of the output gap.
(4) Future monetary policy decisions
With regard to future monetary policy decisions, most central banks engage in forward guidance today, and central bank communication has moved generally in the direction of greater transparency. The ECB, for example, used to be more indirect about their signals, using code words like ‘vigilance’, then opened up during the Euro Crisis of 2012 with Mario Draghi’s famous ‘whatever-it-takes’ speech. Today, the FOMC is quite direct about its expected future path of interest rates, while some central banks around the even publish quantitative guidance for what the path of future policy rates will be, alongside their macroeconomic forecasts. They are, however, quick to emphasise that any forward-looking assessment is conditional on the slate of information currently available.
Finally, there are also questions of the optimal choice of communication tools — should signals be sent by a single person, or on behalf of the entire committee? Are expressions of individual views and opinions allowed and expected? Today, the consensus seems to be a communication-by-committee approach, which are generally more structured, but are inflexible in timing and therefore do not bend to changes in circumstances relevant to monetary policy that need addressing. Hence, occasional speeches and interviews by individual committee members between set meetings offer a way to communicate any changes in views quickly.
Conclusion: What constitutes optimal communication policy?
Thus, this question remains, and much has been done in the past 10 years to present results for the impact of central bank communication on the financial markets and in achieving macroeconomic outcomes. What we do have, however, are key principles for the conduct of central bank communication. The central bank is to provide signals about the private information of central banks, and serves as a coordination for the beliefs of financial market agents. Taking into account the institutional environment in which they operate, the nature of its decision-making process, and the structure of its monetary policy committee, each central bank wields communication tools to instil confidence, establish credibility, and create stability, achieving its main goals. The predictability of monetary policy decisions has improved notably in many countries, and better central bank communication can ‘reduce the noise’. This has also allowed for greater democratic accountability in a world of policy discretion and central bank independence, and will continue to help policymakers judge whether banks are credibly committed to an announced policy. On the other hand, ineffective communication, eg. conflicting voices, actually adds noise to clear signals, and the central bank should perhaps be wary of communicating about issues on which it receives noisy signals itself — the “cacophony of voices” that Alan S. Blinder so vividly describes. Central bank transparency has also been evolving cautiously, because of a perceived irreversibility of these communication initiatives in an ever-increasingly connected world. Central banks therefore need to weigh up the perceived benefits against costs of greater transparency.
With such heterogeneity in central bank practices, we continue to search for that elusive, optimal way for central bank communications. The frontier of research continues to expand, giving us deeper insight into specific channels through which communication affects the real economy. Alongside advancements in our understanding of sentiment analysis and machine learning, economists remain optimistic about the possibility of fine tuning methods of communication, both to their technical audience (economists and the like), and also to the general public.
This article is written by Sean Eio (VP, Economic Research).
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