Nearly two decades ago, Alan Blinder used the Harold Robbins lecture series at the London School of Economics to set out what, at the time, was a minority view on central bank communication – that greater transparency was a good thing, and would help central banks do a better job.1 That view is now widely accepted in mainstream macro thinking, and the past 20 years have seen a transformation in the way central banks communicate. As Carney (2013) puts it:“Research and experience demonstrate that clear and open communications are critical to both the effectiveness and the accountability of monetary policy.”
The Bank of England was an early leader in the push for greater transparency, with the introduction more than two decades ago of its Inflation Report, and, soon after, its ‘fan charts’ for growth and inflation. The key insight of the fan charts – that the world is an inherently uncertain place, and policymakers need to be able to communicate the balance of risks to the outlook – is one that has shaped the Bank’s policy communications since.
The past 18 months have seen a series of initiatives aimed at further enhancing the transparency of the Inflation Report (Table 1).2 The cornerstone of these initiatives has been to provide more effective transparency rather than just more transparency. There is a risk that providing too much information can lead to confusing rather than clear communication, and studies in the literature suggest that a scattergun approach to transparency can at times do more harm than good.3
The move towards enhanced transparency in the Inflation Report has been governed by two criteria:
- First, will the increased transparency enhance the effectiveness of monetary policy – for example, by helping to shape private sector expectations in a way that assists the Bank in meeting its monetary policy objectives?
- Second, does the increased transparency strengthen the Bank’s accountability – something that has become more important than ever in the UK given the Bank of England’s recently expanded responsibilities?4
The remainder of this post expands upon those two criteria in turn.
Transparency and the effectiveness of monetary policy
Why does more effective transparency matter? Because monetary policy is, at its heart, a task of shaping expectations – the expectations of companies, of households, and of financial markets. The success or failure of monetary policy in achieving its primary objectives rests crucially on the ability of the central bank to shape expectations appropriately. Clear communication of the Bank’s own views about the outlook for the economy and the evolving risks, is one way of shaping expectations. In short, the Bank of England’s primary task of achieving the 2% CPI inflation target is made that much easier if companies, households, and financial markets understand what the Bank is trying to do, and how it is trying to do it.5
That central bank communication can take many forms. Communication about the central bank’s longer-run economic objectives – such as its inflation target – can help anchor the wage and price expectations of companies and households.6 Communication about the possible future path of policy rates – for example, the explicit policy guidance recently adopted by the Bank of England – can play an important role in helping the central bank deliver on its objectives, especially in the current environment of highly accommodative monetary policy, where reducing uncertainty about the future path of monetary policy can help support the recovery in economic growth.7 And many of the recent innovations in the Inflation Report have been aimed at communicating more about the key judgements underlying policymakers’ central view of the economic outlook (in other words, the most likely outturn for the economy), as well as the nature of the risks around that central path.
- Since February 2013, the Report has communicated the narrative of the MPC’s central view via a number of ‘Key Judgements’ – in other words, the Report has set out the handful of judgement calls that you need to believe if you are to have confidence in the central narrative of the forecast.
- Since May 2013, Section 5 of the Inflation Report has contained a ‘risks monitoring table’ aimed at helping observers to monitor the degree to which risks to the key judgements are crystallising. For each key judgement, the monitoring table sets out the expected path for a series of short-term indicators that would be consistent with the MPC’s central narrative. If these short-term indicators do not evolve as expected, this provides an early warning signal that parts of the MPC’s narrative are at risk.
- Since February 2014, the Inflation Report has provided longer-term quantitative projections to illustrate its key judgements. For example, the judgement that “the headwinds to growth in advanced economies continue to wane, such that global growth slowly recovers . . . “ is illustrated by projections for world GDP growth, US growth, and Eurozone growth. Again, the quantification of the key judgements helps the clarity of communication of the MPC’s central view. Since February 2014, the Bank has also provided indicative longer-term projections for key endogenous variables such as consumer spending and business investment.
The Inflation Report has also augmented its discussions of the risks surrounding the MPC’s central path. Discussion of risks to the MPC’s projections – communicated via the fan charts for growth, inflation and latterly unemployment, as well as via qualitative commentary in the text of the Report – have always been a key feature of the Bank’s approach to monetary policy communications. Since February 2014, these have been supplemented by the introduction of a ‘scenario box’ which illustrates how different risks to the key judgements could lead to very different outturns for key economic variables.
By focussing on the key judgements underlying the MPC’s central view of the economic outlook, these innovations have been aimed at providing more effective transparency that will help shape the expectations of companies, of households, and of financial markets.
Transparency and central bank accountability
The intellectual underpinnings of operational independence for central banks can be found in the problem of ‘time inconsistency’ faced by politicians (Kydland and Prescott 1977). Time inconsistency occurs when a statement by a decision-maker today on what they might do tomorrow proves to be incompatible with their incentives and objectives once tomorrow comes. So, for example, as an election approaches, politicians may have incentives to renege on unpopular policies whose benefits only accrue over the longer term. Furthermore, observers come to expect the policymaker to renege, thus worsening achievable policy outcomes. In the particular context of monetary policy, a politician may face strong incentives to exploit the short-term trade-off between inflation and unemployment for electoral purposes, although this type of policy can be seriously detrimental to economic welfare in the longer-term.
Operational independence of central banks helps to mitigate the risks associated with time inconsistency, and hence has the potential to enhance economic welfare for all. But it is essential in a democratic society that central banks are fully accountable for their decisions. As Blinder (2008) puts it: “In the end, it is the general public that gives central banks their democratic legitimacy, and hence their independence”.
The Bank of England ensures it is accountable to the general public through many channels – regular appearances by the Governor and other policy committee members in front of Parliament, publication of the minutes of its policy meetings, its Inflation Report and its Financial Stability Report, speeches, interviews and so on. The recent expansion of the Bank’s responsibilities has underscored the importance of accountability. And, as set out in Carney (2014), the Bank has therefore taken steps to strengthen its accountability framework, including the creation of an independent evaluation office – modelled on that of the IMF.
The recent initiatives in the Inflation Report aid accountability by clarifying and quantifying the key components of the MPC’s projections. This makes it easier for outside observers to hold the Bank to account for its performance. And it also facilitates the Bank’s internal evaluation exercises.
- Publication of one-, two- and three-year ahead projections for ‘key judgement’ variables such as world growth, the household savings ratio, and productivity growth helps outside observers to evaluate forecast performance – and, in particular, to facilitate the understanding of why outturns for CPI, GDP growth, and unemployment may differ from the MPC’s central view.
- Forecast evaluation by external observers will also be facilitated by the set of indicative projections for endogenous variables such as consumer spending, business investment, and wage growth. Publication of these variables should also make it easier to compare the MPC’s central view with that of other forecasters, further aiding accountability.
- The Bank has enhanced its own internal evaluation procedures, aided by the quantification of the ‘key judgement’ variables underpinnings its projections. In the second half of 2013, the Bank’s Inflation Report and Quarterly Bulletin published details of an in-depth evaluation exercise, which quantified the degree to which weak world growth, tight credit conditions, heightened uncertainty, and rising import and energy prices had contributed to unexpected developments in GDP and inflation (Hackworth et al. 2013). Similar in-depth exercises will be published in future Inflation Reports.
As set out in Carney (2014), the Bank is committed to continuing to strengthen its transparency and accountability. The Inflation Report will continue to evolve as the Bank seeks to put itself at the forefront of best practice among central banks.
Table 1. Enhancing the transparency of the Inflation Report
Bank of England (2013), “Monetary Policy Trade-Offs and Forward Guidance”, August.
Blinder, A (1998), Central Banking in Theory and Practice, Cambridge MIT Press.
Brazier, A, Harrison, R, King M, Yates, T (2008), “The Danger of Inflation Expectations of Macroeconomic Stability: Heuristic Switching in an Overlapping-Generations Monetary Model”, International Journal of Central Banking, June.
Carney, M (2013), “Monetary Policy After the Fall”, Eric J Hanson Memorial Lecture, University of Alberta, May.
Carney, M (2014), “One Mission. One Bank. Promoting the good of the people of the United Kingdom”, Mais Lecture at Cass Business School, City University, March.
Dale, S, Orphanides, A, Osterholm P (2011), “Imperfect Central Bank Communication: Information versus Distraction”, International Journal of Central Banking, June.
Hackworth, C, Radia, A, and Roberts, N (2013), “Understanding the MPC’s forecast performance since mid-2010”, Bank of England Quarterly Bulletin Q4.
Kydland, F and Prescott, E (1977), “Rules rather than discretion: the inconsistency of optimal plans”, Journal of Political Economy, 85.
Murphy and Senior (2013), “Changes at the Bank of England”, Bank of England Quarterly Bulletin Q1.
Sibert, A (2009), “Is Transparency about Central Bank Plans Desirable?” Journal of the European Economic Association 7 (4), June.
Stockton, D (2012), “Review of the Monetary Policy Committee’s Forecasting Capability”, Bank of England, October.
Woodford, M (2005), “Central Bank Communication and Effectiveness”, National Bureau of Economic Research Working Paper 11898, December.
1 These lectures were subsequently published as ‘Central Banking in Theory and Practice’ (1998), Cambridge MIT Press.
2 Many of these initiatives arose from the MPC discussions of the ‘Review of the Monetary Policy Committee’s Forecasting Capability’, Stockton (2012).
3 The observation that imperfect central bank communication can, in some circumstances, mislead or distract private sector participants has been made in numerous papers, including Woodford (2005), Sibert (2009), Dale et al. (2011).
4 See Murphy and Senior (2013), Changes at the Bank of England, Bank of England Quarterly Bulletin.
5 Under the terms of the Bank of England Act (1998), the monetary policy objectives of the Bank of England are to maintain price stability and, subject to that, to support the economic policy of Her Majesty’s Government, including its objectives for growth and employment. ‘Price stability’ is defined by the Chancellor of the Exchequer, and was reconfirmed in the March 2014 Budget as ‘an inflation rate of 2%, measured by the 12-month increase in the Consumer Prices Index’.
6 See, for example, Brazier et al. (2008).
7 See, for example, ‘Monetary Policy Trade-Offs and Forward Guidance’, Bank of England, August 2013. In February 2014 Inflation Report, the Monetary Policy Committee provided further guidance on the setting of monetary policy once the unemployment threshold had been reached.