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