Central banks should make their policy-decision framework transparent and leave it at that

Central banks should make their policy-decision framework transparent and leave it at that

Originally published on The Australian 


Since financial markets were deregulated in the 1980s, public pressure has pushed central banks to provide ever-greater transparency in their forecasts, including future policy settings. This has gone too far. Central banks should make their policy-decision framework transparent and leave it at that.

The demand for policy forecasts is understandable. People are making critical decisions based on future interest rates – whether for investments, mortgages, wealth management or speculation. But good policy is made by responding to the unfolding circumstances, trimming the sails to the ever-changing breeze.

Circumstances may not – probably will not – evolve as policymakers foresee. What matters is how they respond. Earlier commitments just stall a speedy response.

Central banks’ models and their understanding of how the economy works are imperfect. The post-Covid inflation surge illustrates this.

Policymakers underestimated the power of the fiscal stimulus. Almost everyone missed the extent of the supply-driven inflation surge. The few who foresaw the initial inflation then mistook how inflation would subsequently fall even with tight labour markets.

The sharp rise in interest rates took many by surprise, but this reflected a widespread misunderstanding of what was normality for policy rates, and hence the need for a large adjustment. The “low-for-long” guidance was always going to present an exit challenge and a hostage to fortune.

These misunderstandings and forecasting deficiencies, however, don’t stand in the way of effective policymaking. There is no need for central banks to decide, today, where their policy settings will be in a year’s time. They meet frequently to assess and adjust: to trim their policy stance to the unfolding economy and their evolving understanding of events.

Yet the pressure for greater forecast transparency has been irresistible. US Fed Board members are required to make individual published guesstimates of the Fed Funds rate two years or more hence.

These then become the basis of endless commentary. Decision-making realities mean that these forecasts are, in fact, of little use in predicting the future path of policy. Actual policy settings are inevitably dominated by the Fed chair, backed by the deputy and the deep staff resources. Members’ forecasts say more about their individual biases than the likely path of policy: the hawks predict high rates while the doves’ forecasts are lower.

Key decision-makers have little choice but to forecast that inflation will return to normal (some notion of the “neutral rate”) and inflation will be on target: if not, why wouldn’t they reset current policy to achieve this?

Pressure for official policy prediction has a long history. Alan Greenspan responded with his famous circumlocutory obfuscations: “I know you think you understand what you thought I said but I’m not sure you realise that what you heard is not what I meant”. It was Ben Bernanke who introduced the individual forecasts by board members and promoted the policy of forward guidance.

It turned out badly, not just for the Fed, but for the Bank of England and the RBA. Whatever influence central banks had on market expectations was often-enough misleading, undermining their credibility.

What would be lost by abandoning policy forecasts and forward guidance? The smartest market traders and speculators should welcome the opportunity to benefit from their superior forecasting skills. For those investors, savers, and borrowers who want interest-rate certainty, fixed-rate instruments are the answer.

Commentators would then have to focus on the substantive policy issues, judging central banks by whether they met their inflation mandate rather than the accuracy of official policy predictions. This would shift the focus to where it should be – on anchoring public expectations of future inflation.

Mario Draghi provided the model for forward guidance when he saved a tottering euro in 2012 with his vow to ‘do whatever it takes’ to support the currency.

This simple declaration had all the required elements, with nothing superfluous or misleading. It was clear in its statement of the objective, resolute in its commitment and unspecific as to just what would be done with policy. It worked.

The RBA routinely gives a Draghi-like declaration at the end of its monetary policy announcements. “The board remains resolute in its determination to return inflation to target and will do what is necessary to achieve that outcome.” Nothing more is needed.


Areas of expertise: Regional economic integration; Australia's economic relations with East Asia; international financial flows and the global financial architecture; financial sector development in East Asia