Exploring Central Bank Communication

In terms of central bank communication, why is transparency to be preferred to mystique?

There are two main reasons why transparency is preferable in central bank communication. The first, and possibly most important reason, is for democratic accountability. It is no accident that the first moves towards transparency in the central banking community were associated with ‘Inflation Targeting’ regimes in which the central bank was given the ability to operate an independent monetary policy to achieve an inflation target set by the government. With the power to affect people’s lives that came with operational independence, there was a clear need for the central banks to become accountable for their actions. And so these central banks became obliged by law to explain their actions to law makers, the markets and the general public.

A second reason for preferring transparency to mystique is that monetary policy itself can become more effective if households, firms and financial market participants understand what central banks are trying to achieve. The transmission of monetary policy through the economy will depend on the responses of households and firms and these responses, in turn, will depend on the beliefs of households and firms about where the economy is now as well as their expectations about the future path of the economy and monetary policy. Given that, if the central bank wants its policy to have predictable effects, it needs to ‘steer’ the beliefs of households and firms about the current state of the economy and its future path into line with the central bank’s own beliefs. And then, it needs households and firms to expect the same path for monetary policy as would be implied by the central bank’s reaction function. If this is the case, then monetary policy actions will result in responses of households, firms and the financial markets that are aligned with what the central bank wants to happen, which is in the agreed interest of society.

Modern central banks are much clearer about their communications than the traditional approach of Montagu Norman, but is there still more to be done?

Prior to the 1990s, the traditional approach of central banks to their communications could be summed-up by Montagu Norman’s famous maxim: ‘Never excuse, never explain’. And this view of central banking held until relatively recently. Alan Greenspan, in his autobiography noted that at the Federal Reserve ‘you soon learn to mumble with great incoherence’. Since the advent of inflation targeting regimes, initially in New Zealand, Canada and the United Kingdom, central banks have become ever clearer in their communications. Most recently, the ‘layered’ approach adopted by the Bank of England in its Monetary Policy Report has made it even easier for the general public to understand the key issues affecting the UK economy and monetary policy. The idea is that the four key messages are each given one sentence (with an accompanying picture); the next level – for those who are interested in exploring further – expands on each of these four messages, together with an accompanying chart or two; and for financial market participants and journalists who are interested in the detail, the full Monetary Policy Report lies beneath this in another layer.

Despite these improvements, there is still room to do more. In particular, the Monetary Policy Report presents a forecast for inflation that is conditioned on the financial-markets-implied path for interest rates; that is, it is not necessarily the path that the Monetary Policy Committee expects inflation to follow. However, a quick glance at the newspapers, or a quick chat with friends in the pub, suggests that most people think that it is the Bank of England’s unconditional forecast of inflation. This problem has led some commentators to argue that the Bank should publish its unconditional forecast for output and inflation and include the associated forecast for the interest rate itself. The problem with this sort of ‘forward guidance’ is that the MPC would not want to be taken as pre-committing to a particular path for interest rates, lest households and firms should base decisions on the assumption that this will turn out to be the actual path of interest rates. In an economy buffeted by shocks, the one predictable thing about such a forecast path is that it will turn out to be wrong, as the MPC will have to adjust interest rates to deal with these shocks. To quote Mike Tyson: ‘Everyone has a plan until they get punched in the mouth’!

Market participants kick up a great deal of fuss when they are ‘surprised’ by central bank announcements. Is such criticism fair?

As previously mentioned, one reason for transparency in monetary policy making is that clear communication with financial markets participants can help make monetary policy more effective. Where the beliefs of financial market participants about the state of the economy, the future evolution of output and inflation, and the reaction function of monetary policy makers are aligned with those of the central bank, then monetary policy actions will have the desired effects on the economy. But sometimes participants in financial markets are ‘surprised’ by central bank policy actions and, as noted in your question, they will kick up a fuss about this.

The question as to whether this is fair criticism of the monetary policy makers depends on the reason for the surprise. It may be that central bank communication led to confusion among financial market participants, in which case the criticism is fair. A recent example occurred in November 2021 when the markets were surprised by the absence of a rate rise, despite speeches leading into that particular meeting indicating a likely rise in rates.

But it may be the case that the central bank wants to change the beliefs of financial market participants about the future path of interest rates as a way of better communicating its monetary policy reaction function. For instance, where financial markets are expecting interest rates to rise more rapidly than the monetary policy makers would like to increase them, the central bank may want to signal this, to flatten the yield curve and so loosen monetary conditions. The MPC has on occasion forecast inflation rates below target two and three years out, conditional on the market curve, as a way of signalling to financial market participants that the yield curve needs to flatten. In this case, whether or not they kick up a fuss, it is a good thing that they are surprised and react accordingly. Learning can be painful but sometimes it’s necessary!

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