Plain english vs mumbo jumbo?

Business Standard, 21 June 2006

There is a traditional belief that monetary authories have to be enigmatic, and that market participants have to then zealously watch the central bank to pick up crumbs of information and decipher cryptic clues. Modern monetary economics supports no such position, and there has been a powerful move towards central banks that speak in plain english and are transparent. In a well functioning monetary regime, market participants would only zealously watch the economy, not the central bank. Sound institutions involve a nuanced relationship between data releases, rules, and rate changes.

Alan Greenspan, who is revered as one of the best central bankers ever, was famous for his powers of poor communication, for the low signal to noise ratio in his speeches. It is said that when he proposed marriage to Andrea Mitchell of NBC, he had to say it thrice before she understood what he was asking. Greenspan's reputation as a successful central banker has tempted many lesser mortals to follow in his footsteps by fostering poor communication.

Developments in monetary economics in the last 20 years have emphasised transparency and accountability of central banks. There are three levels of the question: What is the goal of the central bank?, How will it set about achieving this goal, and What will the central bank do next?.

Goal. The first question is about the task of the central bank. In the bad old days, both fiscal policy and monetary policy involved considerable discretionary power. This led to three problems. Discretion introduces unpredictability, it can be used to achieve bad things (like winning elections) and it can be the stage for making mistakes. The two loose cannons of fiscal and monetary policy are responsible for a great deal of the macroeconomic problems worldwide, of the last century. Worldwide, fiscal policy has been increasingly tied down and made accountable by fiscal responsibility legislation. A parallel movement is taking place on similarly tying down monetary policy, by making the central bank accountable for hitting a transparent, publicly stated inflation target.

Procedure. How will the central bank set about achieving the inflation target? There is some algorithm whereby data about the economy is consumed, a judgement is made about fluctuations in expected inflation in the future, and the short rate is changed. The modern view is that the central bank must be 100% transparent on its thought process. Every detail about how the central bank thinks, and how it would respond to various kinds of hypothetical scenarios, should be given out to the world in plain english. Divergent views within the monetary policy committee should be revealed. Diverse econometric models in the central bank should be released in public. The market should have a very accurate picture of how the central bank will behave in the future depending on how the data unfolds in the future.

Next rate hike. In mature market economies, there is a clear clock, such as monthly meetings, where the monetary policy committee decides on rate changes. The committee can obviously not be transparent about whether rates will be raised or lowered next time, for this depends on future data releases. This is the only limited notion of "non-transparency" that has analytical support: nobody can say today what the algorithm will produce at the end of the month, because the data releases till the end of the month are not known today.

At the same time, the market should have a very clear understanding of the mapping from data to rate hikes. Through this, the market should be zealously watching the data releases. Once data has come out, it should be crystal clear how the central bank will behave. There should be zero surprise on the day of the rate hike. The market should not care about what the central bank says, because it knows exactly how the central bank will behave when faced with certain data.

This modern understanding supports explicit, transparent, plain english on the first two questions: What is the task of the central bank, and how will it set about doing it. That leaves only one area where the central bank cannot answer questions: about the next rate hike. Plain english is called for in all three steps; there is no case for old-fashioned central bank mumbo jumbo. The market should be able to build a very clear picture about what the next few data releases will do to the next rate change. In this world, once the market has paid the fixed cost of understanding the algorithm of the central bank, it should be zealously watching the data and not the central bank.

The translation of these ideas into realworld practice began in New Zealand, which was the pioneer in holding the central bank accountable for hitting a publicly stated inflation target, and giving a bonus to the governor based on the extent to which this was done. The most important adoption of these ideas has been in the UK, which began with a CEPR project headed by Eric Roll, that produced a report titled Independent and accountable: A new mandate for the Bank of England in 1993. This report was translated into legislation by Tony Blair and Gordon Brown immediately after they won the elections. Today, the Bank of England is considered the global role model for a sound and well designed monetary institution.

A practice of zealous "fedwatching" implies immaturity of monetary institutions. It implies that the market feels there is ambiguity about monetary policy; that the intentions and algorithm of the central bank have not been soundly communicated. Since the US does not have a sound inflation targeting monetary regime, there is great uncertainy in the transition from Greenspan to Bernanke, since the market does not know Bernanke's goals and algorithm. The test of sound monetary institutions is when speeches by central bank staff do not move markets. As Greg Mankiw said in his blog last week, in a mature market economy, data would move markets, not central bank staff.

In India, we have made progress on one piece of macro policy: the FRBM Act has tied down the loose cannon of fiscal policy. The second task, which needs to now begin, is to enact monetary responsibility legislation, which shifts from the primitive RBI Act of 1934 to the ideas of the UK's Bank of England legislation of 1998.

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