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Thursday, December 01, 2005

Central Bank Communication

Here is William Poole's speech on Federal Reserve Communication of its policy stance. The first part of the speech talks about central bank credibility, rules versus discretion, and inflation targeting, and the speech discusses how these issues emerged as important issues in the rational expectations revolution. The topics in this part of the speech have been presented here many times, so I will skip forward to the section on central bank communication. As the Fed begins to consider how to alter communication about its policy stance, Poole makes several points:

  • First, better information about policy improves outcomes under rational expectations.
  • Second, it's harder to communicate clearly than is commonly appreciated.
  • Third, communicating intentions to the public clearly requires that policy intentions be understood clearly internally and this is an often overlooked benefit of Fed communication with the public.
  • Fourth, the main danger of communicating future intentions is that the Fed will get locked into an expected policy path and will find it difficult to deviate when data indicates it is necessary to do so. More importantly, deviating from the path that markets expect may undermine credibility which is very costly.
  • Fifth, communication of conditionality is, therefore, key. Markets must understand that the statements made by the Fed are conditional upon incoming information.

I want to emphasize that the tricky part of conditionality is getting markets to understand how the Fed will respond to incoming data. It's one thing to say that policy is conditional, but that does not tell markets when or how data will alter the course of policy. For example, will today's favorable inflation report change future policy? Unless the market knows how the Fed will respond as incoming data arrive, merely announcing policy is conditional does not necessarily stabilize market reactions:

Communicating the Fed's Policy Stance, William Poole, St. Louis Fed president: ...My plan is to discuss some of the evolution that has led to policy concern over central bank communication. ... I’ll discuss two aspects of central bank communication. One aspect is “body-language” communication through increased regularity of policy actions and the second is written and oral communication through policy statements, speeches and testimony. ...

Communication through Policy Statements, Speeches, Etc. (8) A rational expectations equilibrium requires that the market have information about the Fed’s policy rule. The more accurate is that information, the more efficient will be economic outcomes. The market learns about the rule above all from what the Fed does. ... Regularities in pursuing policy have made policy more predictable, in the sense that conditional on new information the market has a good idea of the Fed’s response, if any, to the new information. Although predictable policy—the body language—is the most important feature of the current situation, improved policy communication has also played a significant role. Perhaps the most important step the FOMC has taken to improve policy communications was the release of the policy decision immediately following each FOMC meeting, starting in February 1994. Other steps, such as more timely release of minutes of FOMC meetings, have been helpful.(9) ...

As every central banker knows and has most likely experienced, communication is difficult because it is so easy to be misunderstood. Miscommunication adds uncertainty and creates market volatility. ... I know of no model in which adding [uncertainty] to the policy rule improves outcomes for inflation, employment and growth. Increased attention to communication has a benefit that is frequently overlooked—an improvement in the clarity of internal deliberations. In a committee context, explicit understanding of policy goals and agreement on policy direction must precede public communication. We need to know what we want to say before we try to say it. ...

The most important communications issue facing the FOMC currently is whether and how to continue to provide forward guidance on policy decisions. Starting in mid 2003, the policy statement at the conclusion of the FOMC meeting stated that “... policy accommodation can be maintained for a considerable period.” Later, the Committee said that it could be “patient in removing its policy accommodation.” Still later, the Committee said that it would remove accommodation at a “measured pace.”

Even when the federal funds rate was at 1 percent, unpredictable events could have occurred that would have led the Committee to depart from its forward guidance. The setting of policy must be conditional on information at hand, and when information changes sufficiently the policy setting must also change. Historically, the Federal Reserve has not provided forward guidance for fear that it would lock itself into a policy stance that might, under new information, no longer be appropriate. In principle, there is no reason why the Fed cannot explain the nature of the conditionality and convey the view that policy guidance depends on information available at the time guidance is offered. ...

[F]or me the issue is whether under normal and routine circumstances forward guidance will convey information or whether it will create additional uncertainty. If conditionality of policy is understood, then events that lead the FOMC to depart from previously stated forward guidance should not cause difficulty. The market will understand that guidance is not a promise that must be kept to retain credibility but instead a way of summarizing the Committee’s view of the probable direction of policy. Then, when unexpected events move policy a different way, markets will come to the same conclusion about the policy significance of an unexpected event as does the FOMC. ...

    Posted by on Thursday, December 1, 2005 at 05:02 PM in Economics, Fed Speeches, Monetary Policy | Permalink  TrackBack (0)  Comments (1)

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