Central Bank Communication and Policy Effectiveness

Here's Michael Woodford on the value of central bank communication on the likely path of short-term interest rates:

Central Bank Communication and Policy Effectiveness, by Michael Woodford, NBER WP 11898, December 2005: Abstract A notable change in central banking over the past 15 years has been a world-wide movement toward increased communication by central banks about their policy decisions, the targets that they seek to achieve through those decisions, and the central bank's view of the economy's likely future evolution. This paper considers the role of such communication in the successful conduct of monetary policy, with a particular emphasis on an issue that remains controversial: to what extent is it desirable for central banks to comment on the likely path of short-term interest rates? After reviewing general arguments for and against central-bank transparency, the paper considers two specific contexts in which central banks have been forced to consider how much they are willing to say about the future path of interest rates. The first is the experiment with policy signaling by the FOMC in the U.S., using the statement released following each Committee meeting, since August 2003. The second is the need to make some assumption about future policy when producing the projections (for future inflation and other variables) that are central to inflation-forecast targeting procedures, of the kind used by the Bank of England, the Swedish Riksbank, the Reserve Bank of New Zealand, and others. In both cases, it is argued that increased willingness to share the central bank's own assumptions about future policy with the public has increased the predictability of policy, in ways that are likely to have improved central bank's ability to achieve their stabilization objectives. [Open link to version posted at the KC Fed.]

This doesn't follow directly since it's about explicit inflation targets rather than announcing an expected path for short-term rates, but it is related and I've been looking for a reason to talk about explicit inflation targets, commitment, and transparency further because I think there's a mistaken belief from some that commitment is only valuable if it substantially constrains flexibility. But as Mankiw explains in his intermediate level text, this need not be the case. There is value in announcing inflation targets even if it does not tie the hands of central bankers because it holds them accountable for their actions. They can still do mostly as they please, but it's easier to assess policy actions relative to announced goals. This is from Macroeconomics, 5th Ed., by N. Gregory Mankiw, Case Study, pg. 395:

Inflation Targeting: Rule or Constrained Discretion?

Since the late 1980s, many of the world's central banks-including those of Australia, Canada, Finland, Israel, New Zealand, Spain, Sweden, and the United Kingdom-have adopted some form of an inflation target. Sometimes inflation targeting takes the form of a central bank announcing its policy intentions. Other times it takes the form of a national law that spells out the goals of monetary policy. For example, the Reserve Bank of New Zealand Act of 1989 told the central bank "to formulate and implement monetary policy directed to the economic objective of achieving and maintaining. stability in the general level of prices." The act conspicuously omitted any mention of any other competing objective, such as stability in output, employment, interest rates, or exchange rates. ...

Should we interpret inflation targeting as a type of precommitment to a policy rule? Not completely. In all the countries that have adopted inflation targeting, central banks are left with a fair amount of discretion. Inflation targets are usually set as a range an inflation rate of 1 to 3 percent, for instance-rather than a particular number. Thus, the central bank can choose where in the range it wants to be. In addition, the central banks are sometimes allowed to adjust their targets for inflation, at least temporarily, if some exogenous event (such as an easily identified supply shock) pushes inflation outside of the range that was previously announced.

In light of this flexibility, what is the purpose of inflation targeting? Although inflation targeting does leave the central bank with some discretion, the policy does constrain how this discretion is used. When a central bank is told to "do the right thing," it is hard to hold the central bank accountable, because people can argue forever about what the right thing is in any specific circumstance. By contrast, when a central bank has announced an inflation target, the public can more easily judge whether the central bank is meeting that target. Thus, although inflation targeting does not tie the hands of the central bank, it does increase the transparency of monetary policy and, by doing so, makes central bankers more accountable for their actions.⁶

⁶ See Ben S. Bernanke and Frederic S. Mishkin, "Inflation Targeting: A New Framework for Monetary Policy?" Journal of Economic Perspectives 11 (Spring 1997): 97-116.

[JSTOR link to Bernanke and Mishkin paper.]