August 26th, 2014
Last Tuesday the minutes of August’s Reserve Bank of Australia board meeting were released. Market participants speculated about what they would say, currency and bond markets responded to what they did say about house prices and future interest rates, and the precise wording was dissected in great detail by the Australian press.
The words of central bankers like Stevens attract a huge amount of attention. In the US, analysts have scrutinised even the body language of successive US Federal Reserve chiefs.
It’s not surprising that what central bankers do is closely followed. After all, interest rates have a big effect on economic activity, a range of different markets, and investment strategies.
But what is, at first glance, surprising, is that what central bankers say is perhaps as closely scrutinised as what they do. Of course, what they say is informative about what they might do in the future — but there’s more to it than that.
Vague on all counts
Perhaps the most striking feature about how central bankers communicate is that they are typically quite vague. This is so widespread and has become such an art form that it was dubbed “Fedspeak”.
Alan Greenspan’s ‘uncertainty principle’: you can either know what he’s saying, or whether he really means it. But you can’t know both at the same time. Mike Licht/Flickr, CC BY
For example, Alan Greenspan in 2005 told the US House Financial Services Committee:
“Risk takers have been encouraged by a perceived increase in economic stability to reach out to more distant time horizons. But long periods of relative stability often engender unrealistic expectations of it[s] permanence and, at times, may lead to financial excess and economic stress.”
Even the comparatively plain-spoken Glenn Stevens said recently to the Australian House Standing Committee on Economics:
“At some point, if these responses start to gather pace, the sorts of forecasts we are setting out at the moment will very likely prove to be conservative. The frustrating thing is that no one can say when that will happen, or just what might be the proximate trigger.”
Why are central bankers so abstruse? Surely it would be better for them to communicate clearly. Actually, no.
The impossible challenge of being credible and precise
Central banks have all sorts of information about the economy that investors and the general public do not. They use that information to inform future policy. So wouldn’t it be best if they could credibly communicate that information so the market could incorporate that into their decision making as soon as possible?
Yes, but the key word here is “credible”. Imagine for a moment that a central bank could make a pronouncement that was both credible and precise. Being credible, markets would believe it. And being precise, markets would have no doubt what it meant about future policies.
But this very fact would give the central bank a reason to lie. Why? Because there is a trade-off between inflation and output (or unemployment). Different central bankers will have different appetites for how much unemployment they are willing to tolerate in order to keep inflation low.
So, as Nobel Laureates Finn Kydland and Edward Prescott noted long ago, policy makers (such as central banks) suffer from an inherent time-consistency problem. In this setting, all central bankers want to be seen to be “tough on inflation”, but then bankers with less tolerance for unemployment will still want to mimic bankers with more tolerance — so they can be believed to be tough and enjoy low inflation expectations.
But that’s a logical contradiction. So central banks cannot be credible and precise at the same time.
If you think this logic sounds complicated, airy-fairy, and “academic” then you are right. And wrong. It is exactly the reasoning laid out by a Harvard University economics professor in a paper in 1989 in the worlds’ leading economic journal, the American Economic Review. That Harvard professor, Jeremy C. Stein, later went on to become a Governor of the US Federal Reserve. So he’s seen theory and practice.
And his argument is perhaps more pertinent today than ever before. A time where central bankers are trying to balance multiple competing objectives with just one concrete policy instrument: short-term interest rates. Poor Glenn Stevens is trying to juggle inflation, growth, unemployment, the exchange rate and housing prices all at the same time. He needs more than just the cash rate to do that. And to influence expectations at all he must balance the precision and credibility of his language.
What central bankers say communicates a lot more information that the interest rates they set. That’s why central bankers are so careful in their language, and masters of the art of Fedspeak.
Personally, I think “Fedspeak” sells the immutable economic logic behind it a little short. I prefer to think of it as “Greenspan’s Uncertainty Principle”. You can either know what he’s saying, or whether he really means it. But you can’t know both at the same time.
Richard Holden is an ARC Future Fellow.