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Thursday, November 4, 2021

Central Bank Transparency

The Bank of England whipsawed markets today by leaving its policy stance unchanged, despite hints of a tightening that were given out last month. This variability is not particularly surprising to me, so I just want to comment on some of the deeper issues. I believe that I have discussed these topics in the past on my blog, but since I have many new readers, I will run through my thinking again.

My view is that the shift towards greater “transparency” by central banks since the 1990s has been a mistake. As is entirely typical, the root of the mistake was listening to New Keynesians.

Bank of England Back to its Old Tricks

I used to follow Bank of England (BoE) decisions, and so I am somewhat familiar with its institutional structure. The BoE is somewhat unusual in that it has “external” and “internal” members of the policy committee. The relations between the internal and external members (and between the external members and bank staff researchers) were not always smooth, and the external members can view themselves as outsiders within a private club. This dynamic means that policy disagreements that would be hashed out behind closed doors elsewhere get aired in public. The BoE generates a lot of relatively close policy decisions, with 6-3 or even 5-4 votes. This is different than the Federal Reserve, where you at best get a single token dissent, with the dissident having a bug up their posterior about something.

The advantage of the internal/external split is that it might help break up group think. The disadvantage is that BoE communications is a source of confusion. Given the dangers of group think, I cannot complain too loudly about the structure, even though this contradicts my preference for less transparency.

What Should a Central Bank’s Communication Strategy Be?

Let us assume that we have a central bank with an inflation target mandate. In which case, the communications should just state what their current policy stance is, and relate that to the inflation target if conditions warrant. If there is an ongoing financial crisis, it should note that market conditions are disturbed, but that it is taking actions to stabilise the financial system. So we are looking at three to four sentences of actual content, with maybe some boilerplate at the top that gives context for outsiders.

For example, a central bank might now have a statement that reads “The committee has set {policy variables to whatever levels}. Although current inflation rates are above our inflation target, the committee believes that inflation will return to {some level, probably the inflation target} within {horizon}, which means that policy settings did not need to be adjusted.”

The bank could also release its internal forecasts, and let people pore over them without too much guidance. Unless the central bankers are complete amateurs, the forecasts will always show inflation returning to target at the end of the forecast horizon.

This is more transparent that central banks were during earlier eras. For example, during the Monetarist money targeting stupid phase central banks went through, they did not announce what the policy settings were. However, there is no attempt to offer forward guidance.

Don’t Tell Me What You Are Going To Do

Although I argue that instantaneous forward rates should (roughly) equal the expected path of the policy rate, that does not mean that they should go where the central bankers would like them to go. Instead, they should follow what market participants think central bankers will do in the future.

This is very different than the fantasy world of New Keynesian models. In those models, everyone can see the equilibrium forward prices for all economic variables, and central banks magically “select” what the equilibrium path will be. In addition to being obviously crazy, that does not align with the real world, where we do not have access to traded equilibrium paths of economic variables, rather only a vague idea what people’s opinions about them are.

Investment management is sadly now a highly bureaucratic endeavour. Portfolio managers are expected to dream up detailed investment management procedures that they allegedly follow. Although I was not in the allocating capital part of the business, I tagged along to offer observations to colleagues who did that job. Very simply, I would not be very happy to allocate money to investors whose procedure is “we mindlessly believe what central bankers say they are going to do, and invest accordingly.”

If central bankers are worried about a scenario where growth being low, it is in their interest to low ball where they say the policy rate will go. If the risk scenario goes away, they can then say what they actually think. It costs them nothing to do so — but investors stupid enough to listen to them would lose money.

If you want to trade the direction of interest rates (which is not necessarily a good idea), you need to trade against your forecast for the economy, not what central bankers are saying.

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(c) Brian Romanchuk 2021

1 comment:

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