Central banks used to be shrouded in mystery – and believed they should be.1 A few decades ago, conventional wisdom in central banking circles held that monetary policymakers should say as little as possible and say it cryptically. Over recent years, the understanding of central bank transparency and communication has changed dramatically. As it became increasingly clear that managing expectations is a central part of monetary policy, communication policy has risen in stature from a nuisance to a key instrument in the central banker’s toolkit. As a result, many central banks have become remarkably more transparent by placing much greater weight on their communication.
What constitutes an “optimal” communication strategy is, however, by no means clear. The recent debate between Morris and Shin (2002), on the one hand, and Woodford (2005) and Svensson (2006) on the other hand, illustrates that there is still a large controversy on the welfare effects of central bank communication. The recent research on this topic has made several advances but also raises many open questions. A key question is whether communication contributes to the effectiveness of monetary policy by creating genuine news (e.g., by moving short-term interest rates in a desired way) or by reducing noise (e.g., by lowering market uncertainty). There are two main strands in the literature. The first line of research focuses on the impact of central bank communications on financial markets. The basic idea is that, if communications steer expectations successfully, asset prices should react and policy decisions should become more predictable. Both appear to have happened for a great majority of central banks in advanced economies. The second line of research seeks to relate differences in communication strategies across central banks or across time to differences in economic performance.
Despite the benefits that communication can in principle generate, it is no panacea. Poorly designed or poorly executed communications clearly can do more harm than good; and it is for instance not obvious that a central bank is always better off by saying more. In practice, central banks do limit their communications. In most cases, internal deliberations are kept secret. Only a few central banks project the future path of their policy rate.2 And most observe a blackout or “purdah” period before each policy meeting, and in some instances also before important testimonies or reports. The widespread existence of such practices illustrates the conviction of most central bankers that communication can, under certain circumstances, be undesirable and detrimental.
What we know
In a recent review article,3 we survey the impressive number of studies, take stock of what we now know about how central bank communication can contribute to the effectiveness of monetary policy, and identify places where additional research is needed. Several points emerge from this research.
First, no consensus has yet emerged on what communication policies constitute “best practice” for central banks. Practices, in fact, differ substantially and are evolving continuously.4 There is an emerging consensus in the theoretical literature that both the central bank and society are better off with increased transparency. However, a central bank should perhaps be wary of communicating about issues on which it receives noisy signals itself – such as the evolution of the economy. However, there are compelling arguments that honest central bank talk is almost certain to coordinate beliefs in the right direction.
A second point that has emerged is that the predictability of monetary policy decisions has improved notably in many countries. With only a few exceptions, empirical studies to date suggest that more and better central bank communication contributed to this improvement by “reducing noise.” However, the predictability of monetary policy appears to be degraded somewhat when central banks speak with too many conflicting voices, or what is referred to as a “cacophony problem” (Blinder 2004, Chapter 2). When monetary policy decisions are taken and subsequently explained by a committee rather than by a single individual, there is a danger that too many disparate voices might confuse rather than enlighten the public – especially if messages appear to conflict. If done poorly, uncoordinated group communication might actually lower, rather than raise, the signal-to-noise ratio. But the appropriate remedy for this problem, should it exist, is clarity, not silence.
A third finding that has emerged quite clearly from the research is that what might be called “short-run” central bank communication – that is, disclosing central bank views on, e.g., the outlook for the economy and monetary policy – has a substantial impact on financial markets. Official statements, reports, and minutes appear to have the clearest and most consistent empirical effects on financial markets. However, an overall assessment of the effectiveness of different forms of communication requires further empirical evaluation, including obtaining a better understanding about the role of financial market development and sophistication in incorporating such news.
Regarding what might be called “long-run” central bank communication – that is, disclosing the central bank’s goals and strategies – the empirical evidence so far is largely limited to one question: the effect of announcing an inflation target or a quantitative definition of price stability on inflation expectations and inflation outcomes. While important, this is not the only relevant question; research on the links between communication and other macroeconomic variables is essential.
For a variety of reasons, isolating clear effects of announcing an inflation target or a quantitative definition of price stability turns out to be harder than might be expected. But there is clear evidence that it helps anchor inflationary expectations. At the same time, however, it is not the only way to do so. The evidence that announcing an inflation target or a quantitative definition of price stability leads to lower or less-variable inflation is far less compelling.
What we would like to know
This list of research findings constitutes a quantum leap over what we knew at the start of the decade, which was almost nothing. But there is a lot more to learn. Some such areas about which we know still relatively little are the following:
- ·The publication of projected paths for the central bank’s policy rate has been practiced in so few countries for so few years that we have little empirical knowledge of its effects as yet. As more data accumulates, this should be a high-priority area for future research.
- Another important, but barely explored, issue is what constitutes “optimal” communication policy, and how that depends on the institutional environment in which a central bank operates, the nature of its decision-making process, and the structure of its monetary policy committee. Research on that important topic has barely begun.
- Although there is substantive evidence that central bank communications move financial markets in the intended direction and increase the predictability of interest decisions, there is less agreement as to whether communication can help describing the evolution of interest rates in Taylor-rule-like models.
- Finally, nearly all the research to date has focused on central bank communication with financial markets. It is time to pay more attention to communication with the general public. While this will pose new challenges to researchers, in particular with regard to data availability, the issues are at least as important, as it is the general public that gives central banks their democratic legitimacy, and hence their independence, and as the general public’s inflation expectations eventually feed into the actual evolution of inflation, e.g. through corresponding wage claims and savings, investment and consumption decisions, and thus determine whether a central bank is able to achieve its policy objectives.
Blinder, Alan, Michael Ehrmann, Marcel Fratzscher, Jakob de Haan and David-Jan Jansen, 2008. “Central bank communication and monetary policy: A survey of the evidence,” NBER Working Paper No. 13932, April 2008, forthcoming Journal of Economic Literature.
Blinder, Alan 2004. The Quiet Revolution: Central Banking Goes Modern. New Haven, CN: Yale University Press.
Morris, Stephen, and Hyun Song Shin. 2002. “Social Value of Public Information.” American Economic Review, 92(5): 1521-1534.
Svensson, Lars E.O. 2006. “Social Value of Public Information: Morris and Shin (2002) Is Actually Pro Transparency, Not Con.” American Economic Review, 96(1): 448-451.
Woodford, Michael. 2005. “Central-Bank Communication and Policy Effectiveness.” In The Greenspan Era: Lessons for the Future. Kansas City: Federal Reserve Bank of Kansas City, 399-474.
Woodford, Michael, 2008. Vox columns “The Fed's enhanced communication strategy: stealth inflation targeting?” 8 January and “Forward guidance for monetary policy: Is it still possible?” 17 January.
1 Views expressed in this article do not necessarily reflect those of the European Central Bank, de Nederlandsche Bank, or the Eurosystem.
2 See Michael Woodford’s Vox column “Forward guidance for monetary policy: Is it still possible?” 17 January 2008.
3 A. Blinder, M. Ehrmann, M. Fratzscher, J. de Haan and D. Jansen, “Central bank communication and monetary policy: A survey of the evidence,” NBER Working Paper No. 13932, April 2008, forthcoming Journal of Economic Literature.
4 A prominent recent example relates to the FOMC’s change in communication practices, see, e.g., Michael Woodford’s Vox column on this issue