The importance of central bank communication

Central Bank communication across the world has been the subject of much intellectual discourse, but it has almost always been in the context of the communication of monetary policy. That is understandable because monetary policy is at the heart of central banking and also because communication of monetary policy is possibly more challenging than communicating other policies. 

Over the last two decades, central banks have moved towards clearer communication and greater transparency. This has been driven by several motivations. First, central banks have realised that open and transparent communication enhances policy effectiveness. This shift reflects a shift in the theory of monetary policy. Until the early 1990s, monetary policy was strongly influenced by Robert Lucas’ argument that monetary policy affected real variables only if the policy changes were unanticipated. This encouraged obscurity over openness and clarity. Lost in the message was the fact that monetary policy always affected nominal variables like inflation even if fully anticipated. In the 1980s, Finn Kydland and Ed Prescott argued that fully transparent rules rather than discretionary policy changes were more efficient and credible. This was the beginning of the push towards rules over discretion and greater central bank transparency. 

The most eloquent illustration of this shift is the change in the communication strategy of the US Fed. Prior to 1994, the US Fed didn’t even announce the target Fed Funds Rate (FFR); the market was expected to infer the rate from the timing, sequencing and magnitude of its open market operations. In contrast, today, the Fed not only announces the rate but also gives a clear indication of future policy trajectory. Indeed, it is standard practice for central banks these days to indicate the policy rates, the rationale behind the policy action, the expected outcomes, and often, forward guidance on future policy actions. 

While communicating policy after it is made is the standard mode of communication, central banks are taking to communication before policy action. This again is a lesson from experience — that the market does not like unexpected news, and that surprises should be avoided unless surprise is, in rare circumstances, part of the strategy itself. When the Fed announced it would reinvest the proceeds of maturing securities purchased under the first phase of quantitative easing (QE1), the markets were unnerved. In contrast, the elaborate communication exercise that preceded the QE2 delivered the expected announcement effect. QE2 has of course come in for extensive criticism, but that is certainly not because of lack of communication. 

The Reserve Bank of India (RBI) had a similar experience. Both on the way up to the crisis and on the way down, it had to make several off-cycle policy adjustments. There was wide agreement that these measures were expedient but they did not go down well with the market because of the surprise element. This prompted the RBI to revise its communication strategy by introducing, with effect from September 2010, more structured mid-quarter reviews (now bi-monthly). Such frequent policy reviews reduced the need for off-cycle action, minimising the surprise element. In recent times, the RBI has been putting in a subtle message of policy changes through its monthly and annual publications, that sometime escapes attention. 

Sometimes communication, instead of being a vehicle for policy, can be the policy itself. Drawing yet again from the US experience during the crisis, the Fed realised that its repeated announcement/first generation policy signals of keeping rates low “ for an extended period” or “can be removed at a pace that is likely to be measured”, led markets to reach a certain inference on what the “extended period” could mean. The ECB’s use of such code words as “strong vigilance” also belongs to this category. 

Some policy analysts argued that a step that the Fed could consider was to modify the language of the statement (second generation signals as Bank of Canada does) to provide exact information to the markets. This, it was believed, would ease financial conditions as desired. In August 2011, the Fed enhanced its guidance, which until then had stated that the FFR would likely stay at exceptionally low levels “for an extended period”, by replacing the latter with “at least through mid-2013”. Simultaneously, to make its objectives clearer, in January 2012, the FOMC (Federal Open Market Committee) released a Statement on Longer-Run Goals and Monetary Policy Strategy. 

In the Indian context, the RBI typically provides first generation signals in its policy statement. We believe the RBI should think of providing signals that reduce the disconnect with market expectations. 

Another factor that has motivated central banks to place a bigger emphasis on communication is their hard-earned autonomy in the years before the crisis. Central banks have increasingly embraced more open communication to counter the criticism that an autonomous central bank comprising unelected decision makers was inconsistent with a democratic structure. 

Before we conclude, here are two things to remember. First central bank communication is important for the institution to learn, listen and understand. One is referring here not to the standard one-way oral or written communication but to two-way communication between the central bank and its stakeholders, with the central bank remaining largely on a listening mode as the RBI does at periodic intervals. Second, continuous interaction with market (social media included) and all stakeholders is the best strategy for policy effectiveness and helps deflect threats to central bank credibility.
The author is group chief economic advisor, State Bank of India. Views are personal



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