research

The more people understand monetary policy, the happier they are with central banks

Albeit fairly intuitive at first sight, now academic research has lent support to this notion: The more people understand monetary policy, the happier they are with central banks. Put differently, as a recent paper argues: “The less someone knows about central banking, the less likely he or she will be satisfied with the institution.”

Many central banks, from both developed and developing countries, have been running educational programs and reaching out to the wider public over the past years. Adriel Jost of University of St. Gallen and Swiss National Bank (SNB), provides clear justification for such efforts in the paper titled “Is Monetary Policy Too Complex for the Public? Evidence from the UK”:

Average satisfaction with BoE's policy since 2001.

Central banks have increased their engagement in the information and education of the broad public. But what can be said about the nonprofessional’s knowledge of monetary policy and central banking? Based on the Bank of England’s Inflation Attitudes Survey, I construct a score to capture the central banking knowledge of the respondents. I show that the average British person displays limited knowledge of central banking. At the same time, the data reveal that satisfaction with the Bank of England’s policies increases with a better understanding of monetary policy.

Investing energy and money to increase transparency and broaden communication outreach activities to financially educate the public and explain what central banks are doing and how seems vindicated by this analysis. That said, the paper also concludes, and quite rightly, that central banks might benefit from a certain level of financial ignorance among members of the public:

“No one can be forced to learn. People may simply have no incentives to learn about monetary policy, especially if they are generally satisfied with the central bank … All the more, ignorance in monetary policy may be appropriate, as monetary policy knowledge is less necessary in everyday decisions than financial knowledge.

Future of monetary policy communication: Open, clear, explanatory, and aimed at public

Alan S. Blinder, a Princeton University scholar and former Fed official, has made a couple of predictions on the future of monetary policy communication for the next few years. His academic account to a large extent fits my perceptions of the general trend in central banking communication, based on my practical experience with central banks modernizing their policy frameworks. Below I quote, and comment on, two of the Blinder’s six predictions.

Blinder’s prediction # 1: Transparency about monetary policy will increase over time.

Blinder: “I feel confident in predicting this as a generic statement, although the pace and details will vary from one central bank to the next. After all, some are extremely transparent already, while others are less so. But virtually all central banks have been moving in one direction in recent decades--toward greater openness--and I don’t believe that process is over. This prediction derives in part from pretty strong historical evidence that transparency is a one-way street: Once a central bank moves toward greater transparency in some dimension, it never reverts back to its old, less-transparent ways.”

My comment: There is indeed a global trend among central banks towards greater openness, and it is particularly visible in currently less transparent central banks of many low income and developing countries. As soon as a central bank modernizes and aims to become more forward-looking in policymaking, increasing policy and economic transparency becomes necessary. The only detail I would dispute is that there “never” is a way back once a central bank opens up. As illustrated by the recent case of the Czech National Bank, a temporary restriction on transparency, at the very least, remains a viable option at policymakers’ disposal should they decide so in the interest of their policy effectiveness.

Blinder’s prediction # 4: Central banks will keep trying to communicate with the general public, as they should. But for the most part, they will fail.

Blinder: “Much as we may believe that an independent central bank in a democracy should communicate with the citizenry, only a tiny fraction of the citizenry will tune in … You speak one way if you are addressing experts who understand the jargon and dote on every word, quite another if you are talking to members of the broad public who lack both expertise and interest and who are half-listening at best. I am a big believer in democratic accountability, which requires communicating with the broad public. But in truth, the part of central bank communication that matters most is the way policymakers communicate with markets—and for a simple reason: Market participants listen.”

My comment: Here Blinder has a point. As marketing guru Seth Godin has put it, nowadays “there's so much noise, so much clutter... that hoping that (people will) listen closely and carefully enough to figure out what you mean is a recipe for frustration.” And Godin offers a simple alternative: “Maybe, instead of insisting that people listen more closely, you could speak more clearly.” This is exactly what most advanced central banks, with those less advanced in their wake, have been painstakingly striving for: Use as plain and clear language as possible to explain themselves. As Blinder concludes: “It’s high time that central banks, which have travelled a long way down the communications road already, cease viewing words as scarce commodities to be given only grudgingly. Montagu Norman was wrong; they should explain.” Indeed, gone are the days of Montagu Norman, the Governor of the Bank of England from 1920 to 1944, who is often cited as saying that the role of a central banker was: “Never explain, never apologize”.


Blinder made the predictions in a paper titled “Through a Crystal Ball Darkly: The Future of Monetary Policy Communication”, prepared for the Annual Meetings of the American Economic Association, Philadelphia, January 6, 2017.

Never ending debate: Does central bank transparency do more harm than good?

A paper by two Swiss National Bank economists has cast doubt on the benefits of greater central bank transparency and increased communication in enhancing the predictability of monetary policy.

Thomas Lustenberger and Enzo Rossi, in their paper titled “Does Central Bank Transparency and Communication Affect Financial and Macroeconomic Forecasts?”, conclude that central bank openness and too frequent talk by policymakers tend to confuse private forecasters, causing errors in their interest rate forecasts.

The paper provides yet another contribution into the seemingly endless debate among academics and practitioners about the benefits and drawbacks of the shift towards greater transparency and more frequent communication in central banking over the past two decades.

As one would intuitively expect, and I completely agree with based on my experience in working with a number of central banks across the developing world, the paper suggests that there is no single, one-size-fits-all model for transparency and that its effects that vary greatly across countries and variables.

That said, the paper makes a number of important points that are worth considering by policymakers and communication managers in developing countries’ central banks aspiring to raise their policy transparency and enhance communication.

Don’t expect wonders from greater transparency:

  • central bank openness is not an effective instrument to improve the accuracy of private forecasts;
  • the publication of voting records is even detrimental to the quality of interest-rate forecasts;
  • more transparency contributes to aligning single forecasts with each other. From this perspective, transparency seems to provide the anchor by which agents’ forecasting actions are coordinated.

Don’t presume more talk is always better than less talk:

  • the verdict about the frequency of central bank communication is unambiguous. More communication produces forecast errors and increases their dispersion;
  • speaking less may be beneficial for central banks that want to raise predictability and homogeneity among financial and macroeconomic forecasts. We provide some evidence that this may be particularly true for central banks whose transparency level is already high;
  • a higher turnover of governors tends to reduce the precision of interest-rate and inflation forecasts. Greater central bank independence also tends to worsen the quality of forecasts, perhaps by increasing the size of monetary policy committees that may lead to cacophony.

Policy implications of greater transparency and enhanced communication

“… the policy implications are not clear-cut. If the policy objective is to get forecasters to provide more-precise forecasts, our results suggest that transparency is not an adequate tool to achieve it. However, if the objective is to align individual forecasts, then the general normative implication seems to be an increase in transparency.”

“… in order to improve the quality of forecasts of variables that are central to monetary policymaking and align them among professional forecasters, central banks ought to speak less often, especially those that have already achieved a certain degree of transparency.”

Caveat: Don’t read too much into the results of this study…

One important caveat is in order, a point made by the authors themselves: The study and its framework cannot be seen as definitely answering the question whether more or less communication is desirable and whether the degree of transparency should be increased or lowered.

“Our paper only studies the effect of communication and transparency on forecast accuracy and dispersion. Although the impact of communication and transparency on this dimension is important, there may be many other beneficial (or harmful) effects of giving public speeches or being transparent on, for instance, accountability, the public’s understanding of monetary policy, and trust in the central bank.”

Very true. One can never underestimate the benefits of well-designed communication in promoting the understanding of monetary policy, and with it developing public trust in the central bank.

Fresh contribution to settling “The Inflation Targeting Debate”

The inconclusive debate among academic economists about the merits and macroeconomic consequences of inflation targeting (IT) has just received a fresh impetus that is particularly relevant for developing countries aspiring to adopt IT.

The proponents of IT have argued that enhanced transparency and accountability associated with this monetary policy framework allow IT central banks to more firmly anchor inflation expectations. This is providing policymakers with more room to expand the economy in the face of adverse shocks without jeopardizing the credibility of monetary policy.

A recent IMF working paper, titled “Settling the Inflation Targeting Debate: Lights from a Meta-Regression Analysis”, has offered the following key findings on “The Inflation Targeting Debate”:

“… IT adoption is likely to bear more fruits (price and output stability) when fully implemented in developing countries. Indeed, monetary policy credibility has yet to be earned in these countries, such that a successful implementation of IT may help anchor inflation expectations more firmly and close the credibility gap.

But key preconditions need to be met for IT to yield beneficial effects, including notably sound fiscal positions, deep financial system, and greater exchange rate flexibility.”

A hike in inflation targets seen as a cure for stubbornly low inflation

A group of economists, including former Central Bank of Ireland chief Patrick Honohan, has spoken in favor of raising central banks' inflation targets to meet their price stability mandates and boost their economies.

The latest Geneva Report on the World Economy:

Although policymakers have tools for stimulus at the lower bound, these may not always be enough. We therefore also consider adjusting policy frameworks to reduce the risk that nominal rates hit zero. Of the many proposals out there, the most obvious and simplest of such adjustments would be a modest increase in central banks’ inflation targets.

Perhaps the most common reason that policymakers have resisted raising the inflation target is the concern that credibility will suffer. We believe this concern is unwarranted and misplaced. Central banks should seek credibility for their commitment to meet their ultimate goals – full employment and price stability – not for their commitment to a particular number for the inflation target. A greater risk to central bank credibility may be the protracted inability to meet their mandates at the current low targets, due to the lower bound constraint.

The paper joins a raft of academic publications offering suggestions on how to prevent central banks from becoming increasingly impotent to deliver on their promise to engineer 2 percent inflation when interest rates have reached the zero lower bound.

True that the inability of central banks, in many developed countries around the world, to meet their declared 2 percent objectives poses a clear credibility threat.

South Africa's communication change aids policy predictability

A recent South African Reserve Bank's (SARB) paper analyzed the impact of change in communication adopted in January 2014 on the predictability of monetary policy by economists and financial market participants.

Throughout 2014 the South African Reserve Bank (SARB) explicitly communicated that monetary policy was on a rising cycle until normalisation is reached.

The results based on descriptive analysis and a nonparametric change points model confirm the influence of the "rising cycle" talk in shaping expectations of both economic experts and financial market participants on the future path of the reaction function of the SARB. Besides the surprise effects of January 2014, agents clearly predicted subsequent rate hikes based on the guidance received from the SARB. Previous rising interest rate cycles do not portray the same degree of predictability by analysts.

The paper bridged the gap existing in literature on the predictability of monetary policy by market participants in South Africa, and provides a useful case study for other countries in Africa and other developing countries seeking to enhance communication on monetary policy.

Revolution in monetary policy?

David Marsh, Managing Director of The Official Monetary and Financial Institutions Forum (OMFIF), on what he dubbed the "monetary about-face" by James Bullard, the hawk-turned-dove St. Louis Federal Reserve Bank president:

James Bullard, St. Louis Fed President

James Bullard, St. Louis Fed President

If other members of the rate-setting Federal Open Market Committee adhere to the St. Louis Fed’s ‘new narrative’, this could mark a revolution in monetary policy.

Janet Yellen, the Fed chair, does not appear to have been consulted about Bullard’s announcement. Although some might believe his radical rethink represents a challenge to her authority, she can take some comfort from the conversion of a one-time hawk to an adherent of her own somewhat dovish stance.

Marsh said Bullard's narrative could seal the "dot plot" chart's fate:

If momentum for the ‘new narrative’ gains ground, Bullard could trigger the dot plot’s demise – a feat in which he would no doubt take quiet pride.

The so-called "dot plot", representing U.S. policymakers' assessment of the future rate path, has been quite often criticized for being misleading, in particular for lacking clarity on uncertainty surrounding the rate projections.

Bullard's presentation of his "new narrative" is available on St. Louis Fed's website.

Chart your own U.S. rate outlook

The Federal Reserve Bank of Cleveland has constructed the projections of federal funds rates from seven simple monetary policy rules, based on three sets of forecasts for economic conditions. The new tool even helps anyone customize their own simple policy rule.

The federal funds rates use forecasts available as of June 23, 2016.

The federal funds rates use forecasts available as of June 23, 2016.

Simple monetary policy rules typically provide a relationship between the central bank’s policy rate ... and a relatively small number of indicators on real economic activity and inflation.

Monetary policymakers often compare and contrast the federal funds rates implied by different simple monetary policy rules, use simple rules as an input in the decision-making process, and use simple rules to help communicate decisions to the public.

One can download the spreadsheet from Cleveland Fed's website to customize their own simple monetary policy rule and economic forecast.

Good stuff.

Fed's communication found able to massage long-term rates

The Federal Reserve Bank of San Francisco, in an Economic Letter on "Fed Communication and the Zero Lower Bound":

... although the zero bound prevented the Fed from using its main conventional monetary policy tool, it did not constrain the Fed’s ability to affect long-term interest rates through communication with the public.

My interpretation: Intuition (that policy communication is anything but poweless) supported by study based on hard facts. Food for thought for policymakers in a number of developing countries who seem to remain shy of engaging in more active public communications.

How did the study measure Fed communication?

The Fed, and a number of other central bank, relied on other tools — including communication — to work around the constraints of being unable to lower the federal funds rate below zero. In evaluating the use of communication as a policy tool to overcome the zero bound constraint, the study constructed a measure of Fed communications based on textual analysis of newspaper articles and estimated how those messages affected interest rates before and during the ZLB period.

On the methodology used, the San Francisco Fed said:

... we construct a Factiva semantic orientation (FSO) by first collecting from the Factiva database all news articles in English that contain the words “Fed,” “Federal Reserve,” or “FOMC” in the headline that appear the day before, the day of, and the day after the communication date. That database provides a daily clipboard of articles from major world newspapers. From these articles, we select all sentences containing at least one of the following words: rate, policy, statement, announcement, Fed, FOMC, and Federal Reserve. We then count the number of times the words “hawkish,” indicative of a tight monetary policy stance, and “dovish,” indicative of a looser policy stance, are used in the selected sentences. The FSO is the ratio of the number of hawkish to dovish mentions. Therefore, a larger FSO value suggests that the communication is interpreted as more hawkish than dovish, that is, having a relatively tighter policy stance.

Our communication dates are days of FOMC statement releases and speeches by the Federal Reserve Chair. We compare the effects of Fed communications during the pre-ZLB period (May 1999 to November 2008) with those during the ZLB period (December 2008 to December 2014). This yields a sample of 151 communication dates and FSO scores during the pre-ZLB period and 89 during the ZLB period.

Estimated yield changes following Fed communication surprises

Estimated yield changes following Fed communication surprises

The figure above neatly illustrates the main findings:

... longer yields, continue to respond to communication surprises in a way that is basically unchanged relative to the pre-ZLB period.

... despite the constraint on the Fed’s ability to influence short-term yields during the zero-bound period, communications continued to allow the Fed to affect longer-term yields.

Study on households' inflation expectations: Target matters

The Bank of England's Quarterly Bulletin, answering the critical question for an inflation-targeting central bank: How are households' inflation expectations formed?

People’s expectations about future inflation are an important influence on the current rate of inflation: when people believe that inflation will be at target in the medium term they set wages and prices in a way that is consistent with those beliefs.

The study was conducted just on the UK economy, but its conclusions have wider relevance.

Not surprisingly, one of the primary drivers of inflation expectations are recent changes in prices in shops. Still, it is good to see that the level of an inflation target does indeed play a role over the longer run.

Households’ inflation perceptions are an important influence on the inflation expectations of many households, particularly at shorter horizons. And historically, changes in inflation perceptions are estimated to be associated with a similar scale change in one year ahead inflation expectations.

The relationship between changes in CPI inflation itself and households’ inflation expectations is far less strong, and not statistically significant at longer horizons.

Households’ inflation expectations, particularly at longer horizons, are also influenced by a wider range of macroeconomic factors, including the inflation target.

Worth reading in full.