Winner of the New Statesman SPERI Prize in Political Economy 2016

Friday, 27 June 2014

Monetary policymakers as boyfriends

An MP who is a member of the Treasury Select Committee has described the Bank of England as an unreliable boyfriend: “one day hot, one day cold". City economists make similar complaints. The same is frequently said in the US about supposed Fed communication failures. Are these complaints justified?

In judging whether a central bank is really ‘blowing hot and cold’, we need to distinguish between public information about the economy on the one hand, and how policymakers will behave given new information on the other (in technical terms, their ‘reactions functions’). If you start flirting with your boyfriend’s best mate, you should not be surprised if he starts going a little cold. If, on the other hand, he had been attentive and considerate until the World Cup started, since when you have been completely ignored, you have probably learnt something about him that you did not know before.

The problem is that we cannot know for sure how each MPC or FOMC member will react to new bits of data as they emerge. So when Mark Carney in his Mansion House speech said “There’s already great speculation about the exact timing of the first rate hike and this decision is becoming more balanced.” he could have just been reflecting the fact that recent data had been surprisingly strong. As everyone had seen this data, there was no useful additional information in that statement.

However he went on to say “It could happen sooner than markets currently expect.” The intent of that statement is clear. For some reason markets had not reacted to this recent data (and therefore advanced their expectations about when the first rate increase would occur) in the way Mark Carney or the MPC as a whole had done. So they had got the Bank’s reaction function wrong, and Carney was telling them so.

This is why the market reacted strongly to Carney’s speech, and Carney intended them to do so. The trick was to reference something tangible - the market’s forecast for when interest rates were likely to rise. But this raises an obvious question. If part of the Bank’s communications strategy is to make comments about market forecasts of interest rates, wouldn’t it be both clearer and more efficient to have the Bank’s own forecast about interest rates. This is a point that ex-Bank economist Tony Yates makes here.

I have argued for this for some time (e.g. here, para 105), and was therefore enthusiastic when the Fed started to publish rate forecasts just after I started this blog. The idea is obviously not to commit the central bank to some path: a forecast is a forecast. Nor is the idea that the central bank somehow knows more about the data than the market, or that its ability to forecast is better. What publishing a forecast allows the market to do is get a better idea of character of their ‘boyfriend’. (It also allows the public to check that their boyfriend is not being time inconsistent, as I also explain here.)

It is only a matter of time before the Bank of England does this, and continues in its tradition of following the Fed. One interesting question of detail remains, however. Should the Bank publish a single forecast, or follow the Fed and publish the forecasts of each MPC member? (I give an example of the FOMC ‘blue dots’ in this post.) There are arguments for both. The Bank publishes a forecast for inflation and other aspects of the economy, but only on the basis of market guesses of future rates. It would be much more efficient and informative to publish forecasts based on the Bank’s best guess about the future path of interest rates.

The problem with having just one forecast is illustrated by the Carney speech. Was Carney at the time giving his view, or the view of the MPC? If the latter, how unanimous was that view? If subsequently a member of the MPC says something different, is that consistent with the majority view or a change? This problem becomes particularly acute when new MPC members replace old. Questions such as these can only be answered if individual MPC members give their own personal forecasts, as FOMC members currently do but with, in addition, their names attached.

When it comes to monetary policy, we have not one but many ‘boyfriends’. Now boyfriends can get annoyed if you keep asking them ‘what are you thinking’, but in this case we do rely on them (and pay them) rather a lot, so I think we are entitled to know.   

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