Central Banking as Management of Expectations – Woodford’s paper big buzz, and for good reasons.

The last 15 years have seen a remarkable revolution in both the conduct of and the common understanding of monetary policy around the world. This revolution has encompassed instruments, with an increased emphasis on transparency about short and medium run central bank policy planning and decreased emphasis on intermediate targets such as monetary aggregates.

This revolution has also encompassed objectives, with an increased emphasis on medium run inflation targets. However, the objective question cannot be separated from the instrument question. At the heart of this revolution is a change in perspective about what monetary policy is all about. In particular, inflation targeting is seen as a key component of transparent monetary policy.

Having made this initial point, one case that fits the general storyline is Ben S. Bernanke, Chairman of the Board of Governors of the Federal Reserve System (From February 2006 through January 2014,) advocacy of inflation targets, which as an academic and Fed governor was based much more on the transparency and communication advantages of the approach and not as much on the specific choice of target. Continued research on alternative intermediate targets for monetary policy would certainly be worthwhile.

At this critical moment of great changes, Mike Woodford’s (2012) paper is making a big buzz, at the Conference De Nederlandsche Bank 200 years: Central banking in the next two decades, and for good reasons. Woodford’s paper discusses two of the main alternatives, that have been the focus not only of considerable recent discussion, of the strategic interaction and expectations formation to adequately address the real questions on central bank communication policy, models of social value of information and optimal communication in strategic settings.

The first of these is forward guidance — explicit statements by a central bank about the outlook for future policy, in addition to its announcements about the immediate policy actions that it is undertaking. Forward guidance enhances transparency through two channels. It gives guidance on the expected level of future interest rates, conditional on the outlook for price stability. And it reduces uncertainty about that level by strengthening communication on CB:s reaction function.

Second, in a market economy, transparency and communication are central to the effectiveness of monetary policy. Together, a credible objective and a well-understood reaction function allow financial markets and the public to form reasonable expectations about central banks future interest rate policy. This in turn gives the central bank the capacity to influence interest rates at longer maturities and steer broader financial and economic conditions. This is what Mike Woodford has called “management by expectations”. 

The best social policy is to have a good economic policy

For several decades now, the Fed and other central banks have worked to anchor inflation expectations in the vicinity of 2 percent and to explain the associated policy approach.

In this view, monetary policy is at its heart the problem of managing and coordinating expectations in the economy. The instruments under the direct control of the central bank, such as overnight interest rates are less important than the messages the central bank sends.

Third, the policy stance may also be affected by a continued appreciation of the exchange rate. The exchange rate is not in itself a policy target, but a rise in the exchange rate, all else being equal, implies a tightening of monetary conditions, a downward impact on inflation and potentially a threat to the ongoing recovery. This encourage the speculative side of strategy. This assessment, however, needs to take in the whole picture.

On the whole, the importance of communication strategy for policy effectiveness follows from a fundamental feature of the kind of problem that a central bank is called upon to solve. In Mario Draghi, President of the ECB, speech at DNB 200 years in Amsterdam, 24 April 2014. Communicating clearly allows the public to understand how monetary policy will respond when a given shock hits, and in turn to have well-anchored inflation expectations.

It is important for the public to understand the central bank’s actions, to the greatest extent possible, not only for reasons of democratic legitimacy | though this is an excellent reason itself, given that central bankers are granted substantial autonomy in the execution of their task | but also in order for monetary policy to be most effective. For not only do expectations about policy matter, but, at least under current conditions, very little else matters.

A transparent central bank serves the general public, by improving understanding of its actions and accountability for its decisions. And a transparent central bank contributes to its own mission, by steering expectations and making its monetary policy more effective. Hence, judgement is likely to play a greater role in decision-making, and this involves trade-offs that need to be explained. At the same time, decision-making by committee reflects more than the sum of the pre-established views of its individual members. What counts is the quality of the arguments and the contributions made towards reaching a common decision.

“In the pre-crisis times, these expectation effects worked relatively smoothly. In crisis conditions, however, the implementation of monetary policy inevitably changed. We were forced to turn to unconventional measures to fulfil our mandate”, says Draghi in his speech.

Explaining a more complex reaction function.

The modern perspective views monetary policy as a strategic problem: Nevertheless, even with a transparent and credible objective, crisis conditions make it unavoidably harder for observers to predict how central bank will respond to unusual and sometimes unforeseeable circumstances, and which measures could be deployed. This in turn makes it harder for monetary policy to steer expectations about future policy. There are two main challenges here..

First, the possibility to use current changes in the short rate to signal the policy response to a changing inflation outlook. Second, the different contingencies in crisis conditions and the policy measures associated with them are unfamiliar to the public.Thus, more active communication on CB reaction function is needed.

Communication and transparency have become more important for central banks like the ECB in recent decades, and will become even more important in the decades to come. A transparent central bank is not only more accountable, but also more effective in implementing its monetary policy.

The purpose of enhanced transparency is to respond to these challenges: to reduce uncertainty about the ECB:s future policy intentions and to clarify CB:s reaction function in unusual circumstances, explain President of the ECB Draghi.

It seems clear enough in theory that, if a central bank can influence expectations about future policy, this should be an important addition to its toolkit. But to what extent are central-bank announcements actually able to influence expectations in the way that a central bank desires?

The question is not a simple one to answer, but recent events provide many more examples of attempts at forward guidance, so that at least some grains of empirical evidence are now available. The release of the statement have an almost instantaneous effect on market expectations (Campbell et al. 2012). These changes in expectations about future policy furthermore affected behavior, at least in asset markets.

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