Ben S Bernanke: Fedspeak
Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve
System, at the meetings of the American Economic Association, San Diego, 3 January 2004.
The references for the speech can be found on the Board of Governors of the Federal Reserve System's website.
* * *
There was a time when central bankers did not talk to the public. Montagu Norman, the Governor of
the Bank of England for a quarter of a century after the First World War and a highly influential figure
in his time in central banking circles, was notorious for his reclusiveness, both personal and
professional. According to his biographer, Norman lived by the maxim, "Never explain, never excuse"
(Boyle, 1967, p. 217). Norman was hardly unique. Central bankers long believed that a certain
"mystique" attached to their activities; that making monetary policy was an arcane and esoteric art that
should be left solely to the initiates; and that letting the public into the discussion would only usurp the
prerogatives of insiders and degrade the effectiveness of policy.
In contrast to this tradition of secrecy, central banks around the world have become noticeably more
open and transparent over the past fifteen years or so. Policymaking committees have adopted
various mechanisms to enhance their communication with the public, including more informative policy
announcements, post-meeting press conferences, expanded testimony before the legislature, the
release of the minutes of policy meetings, and the regular publication of reports on monetary policy
and the economy.
This increased openness is a welcome development, for many reasons. Perhaps most important, as
public servants whose policy actions affect the lives of every citizen, central bankers have a basic
responsibility to give the public full and compelling explanations of the rationales for those actions.
Besides satisfying the principle of democratic accountability, a more open policymaking process is
also likely to lead to better policy decisions, because engagement with an informed public provides
central bankers with useful feedback in the form of outside views and analyses. Yet another benefit of
full and timely release of information about policy decisions and their rationales is a reduced risk that
market-sensitive information will dribble out through inappropriate channels, giving unfair advantage to
some financial market participants.
Admittedly, for many central banks, including the Federal Reserve, progress toward greater
transparency has come in halting steps and not without trepidation. For example, the decision to
announce changes in the target for the federal funds rate immediately after meetings of the Federal
Open Market Committee (FOMC) was implemented only in phases and after considerable
soulsearching by FOMC members. In retrospect, however, I think that most central bankers, both in the
United States and abroad, would agree that greater openness has been beneficial to central banks as
institutions and for the advancement of their policy objectives.
Although the presumption today is that - absent compelling reasons to the contrary - central banks
should strive for transparency, some basic questions about what, how, and to what end central banks
should communicate with the public remain decidedly open. In my talk today I will put aside broader
considerations such as democratic accountability and consider these questions as they bear on the
ability of central banks to make monetary policy more effective and to improve macroeconomic
performance. Before proceeding, I should emphasize that the views I will express today are not
necessarily those of my colleagues on the Board of Governors or the Federal Open Market
Committee.
Why central bank communication matters for policy effectiveness
Can central bank talk - Fedspeak, in the vernacular of the U.S. media and financial markets - make
monetary policy more effective and improve economic outcomes? To see why communication may be
an integral part of good monetary policymaking, recall that the Federal Reserve directly controls only a
single short-term interest rate, the overnight federal funds rate. Relative to the enormous size of global
financial markets, the market for federal funds - the market in which commercial banks borrow and
lend reserves on a short-term basis - is insignificant. Control of the federal funds rate is therefore
useful only to the extent that it can be used as a lever to influence more important asset prices and
yields - stock prices, government and corporate bond yields, mortgage rates - which in turn allow the
Fed to affect the overall course of the economy.
Of course, basic financial theory implies that a link does exist between short-term interest rates, such
as the federal funds rate, and longer-term rates, such as Treasury bond yields and mortgage rates. In
particular, longer-term yields should depend in part on market expectations about the future course of
short-term rates. For example, with the current setting of the funds rate held constant, any arriving
news that leads bond market participants to expect higher future values of the funds rate will tend to
raise bond yields and lower bond prices. The link between long-term bond yields and market
expectations of future monetary policy actions is familiar to all financial-market participants and has
been well supported by recent empirical research. For example, Antulio Bomfim has demonstrated
that the shape of the term structure of Treasury yields can be effectively described by a two-factor
model, in which the first factor corresponds to the current setting of the funds rate and the second
factor closely approximates medium-term monetary policy expectations (Bomfim, 2003).
The fact that market expectations of future settings of the federal funds rate are at least as important
as the current value of the funds rate in determining key interest rates such as bond and mortgage
rates suggests a potentially important role for central bank communication: If effective communication
can help financial markets develop more accurate expectations of the likely future course of the funds
rate, policy will be more effective (in a precise sense that I will explain further soon), and risk in
financial markets should be reduced as well.
It is worth emphasizing that the predictability of monetary policy actions has both short-run and
long-run aspects. A central bank may, through various means, improve the market's ability to
anticipate its next policy move. Improving short-term predictability is not unimportant, because it may
reduce risk premiums in asset markets and influence shorter-term yields. But signaling the likely action
at the next meeting is not sufficient for effective policymaking. Because the values of long-term assets
are affected by the whole trajectory of expected short-term rates, it is even more vital that information
relevant to estimating that trajectory be communicated. As I will argue later, this can usually be done
only by providing information about the central bank's objectives, assessment of the economy, and
policy strategy.
Communication, asymmetric information and learning
Ideally, what should central bank communication try to achieve? In an important analysis of the issue
of central bank transparency, my FOMC colleague William Poole laid out a benchmark case in which
the potential benefits of communication would be fully realized (Poole, 2003). In this benchmark case,
the central bank has well-defined objectives and pursues regular and systematic policies consistent
with those objectives. More important for our purposes, in this idealized world, financial markets are
highly efficient and well informed. In particular, financial-market participants have access to all the
information that the central bank uses in making policy decisions. Let us call the premise that the
central bank has no significant information advantage over the private sector the assumption of
symmetric
information.
If the conditions of systematic policymaking, financial-market efficiency, and symmetric information all
held, then one might hope that the economy would converge to a rational expectations equilibrium, in
which participants in financial markets would need only to analyze incoming, publicly available
economic data to make efficient forecasts of future Federal Reserve actions.1 In this benchmark case,
there would be no marginal benefit to central bank communication, beyond whatever was necessary to
support this equilibrium in the first place.
Of course, to describe this idealized benchmark case is to recognize that it is at best an approximate
not
description of the economy in which we live. In practice, financial-market participants generally do
have as much information as monetary policymakers do about a number of key inputs to policymaking,
including the policymakers' own objectives, their (possibly implicit) model of the economy and the
monetary transmission mechanism, their assessment of the economic situation (including both
asymmetry of
forecasts and the risks to the forecast), and their policy strategy. To the extent that this
information between the central bank and the financial markets is quantitatively important - and I will
present some evidence on this point shortly - financial markets will not price bonds and other assets
efficiently (relative to the information possessed by the central bank), and scope may exist for central
bank communication to improve the effectiveness of monetary policy and the overall performance of
the economy.
A skeptic might argue that noise and other sources of pricing inefficiency pervade the financial
markets, so that improving the predictability of monetary policy is of limited importance in practice,
except perhaps to a few brokers and traders. To the contrary, there is good reason to believe that
information asymmetries between the central bank and financial markets may matter a great deal for
economic welfare. A theoretical basis for this view is provided by the lively recent literature on adaptive
learning and monetary policy. This work has shown that, when the public does not know but instead
must estimate the central bank's reaction function and other economic relationships using observed
data, we have no guarantee that the economy will converge - even in infinite time - to the optimal
itself
rational expectations equilibrium.2 In general, the problem is that the public's learning process
affects the behavior of the economy - for example, as when expectational errors by bond traders affect
interest rates and thus a wide range of economic decisions. The feedback effect of learning on the
economy, this literature has shown, can in principle lead to unstable or indeterminate outcomes. More
generally, the dynamic behavior of an economy with asymmetric information and learning may be
radically different from the behavior of the same economy in the optimal rational expectations
equilibrium.
A particularly interesting analysis of the implications of learning for monetary policy and central bank
communication has been provided in a series of papers by Athanasios Orphanides and
John C. Williams (2003a, 2003b). Orphanides and Williams study model economies in which the
public is assumed to know the general nature of the economy's underlying structure but not the
precise quantitative magnitudes describing that structure. Specifically, these authors consider a model
in which the public is assumed to know the form of the equation describing the dynamic behavior of
inflation but not the parameters of that equation, which depend on the (unobserved by the public)
objectives and preferences of the central bank. Orphanides and Williams assume that, to learn the
parameters of the process that generates inflation, people must apply standard statistical methods to
observed data on inflation and other macroeconomic variables.
Obviously, in assuming that people know the true economic structure with certainty, and that they infer
the underlying parameters of that structure using formal statistical methods, Orphanides and Williams
and others in this literature are attributing much greater knowledge and sophistication to the public
than exist in the real world. Nevertheless, the behavior of their model economies with learning can be
quite different from that of the rational expectations analogue, in which the public is assumed to have
full and symmetric information. For example, these authors show that the economy with learning is
prone to episodes of stagflation, or combinations of high inflation and low output. The logic is as
follows: When people are learning about the inflation process, an increase in inflation that would be
only temporary and would leave expectations unaffected in a rational expectations world, may instead
lead the public to infer that the long-run average rate of inflation is higher than previously thought. The
rise in the public's inflation expectations affects wage- and price-setting and other economic decisions
and thus raises actual inflation. In a vicious cycle, the higher rate of realized inflation further increases
inflation expectations, forcing the central bank to tighten policy. The result is inflation that is
unnecessarily high and output that is unnecessarily low.
Several insights come from this and other contributions to the literature on adaptive learning in
macroeconomics. First, the fact that the public must learn about underlying economic relationships
changes the nature of the optimal monetary policy. In general, with learning, the central bank's optimal
policy involves exerting a tighter control on inflation than it might otherwise exert, to avoid the
possibility that inflation expectations will drift randomly higher (or lower). Thus, this approach
formalizes the idea that a central bank should work actively to "anchor" inflation expectations within a
narrow range. Second, efficient policy in this world requires that policymakers pay attention to
information (for example, from surveys) about the public's expectations of inflation and other variables;
if these appear not to be converging toward the desired levels, then a policy response may be
warranted.3 Finally, and most important for my purpose today, communication by the central bank may
play a key role in helping improve economic performance. For example, in the models analyzed by
Orphanides and Williams, the provision of information by the central bank about its long-run inflation
objective or its economic forecasts generally leads to more favorable policy tradeoffs and better
economic outcomes.
The work on adaptive learning by Orphanides and Williams and others is largely theoretical, but in my
view it is highly relevant to understanding modern U.S. monetary history. A leading example is the
stagflationary period of the 1970s, in which astute observers recognized that high and unstable public
expectations of inflation, themselves generated by poor macroeconomic policies that allowed inflation
to get out of control, greatly increased the complexity and cost of restoring stability.4 More recently,
Marvin Goodfriend (1993) has identified several instances of what he calls "inflation scares,"
apparently autonomous increases in inflation expectations that raised long-term bond yields and
forced a tightening of monetary policy that could have been avoided if expectations had been better
anchored. The view that adaptive learning and asymmetric information are crucial to understanding
recent monetary history is apparently shared by the developers of the Federal Reserve's primary
econometric model, the FRBUS model, which relies heavily on these assumptions (Brayton et al.,
1997). Simulations of that model suggest both that adaptive learning is needed to explain the
observed responses of the financial market and the economy to monetary policy actions, and that
asymmetric information and adaptive learning lead systematically to inferior macroeconomic
outcomes, as implied by the work of Orphanides and Williams and others.
Of course, the situation in the United States is much better today than in the 1970s; both inflation and
inflation expectations are much more stable, and better economic outcomes have been the result. But
is there still scope for improvement? I will present some evidence to suggest that there is and then
conclude by discussing how communications policies could help anchor and stabilize the system more
firmly.
Evidence on the effectiveness of Fed communication
In the past decade, the Federal Reserve has taken a number of significant steps toward increased
transparency, including announcing decisions about the federal funds rate promptly after FOMC
meetings, indicating first a policy "bias" and then a "balance of risks" assessment in post-meeting
statements, and making the minutes of policy meetings publicly available (with a lag of about eight
weeks). Members of the FOMC have also made greater use of vehicles such as testimony and
speeches to convey their assessments of the economy and their policy inclinations to the public. How
effective have these efforts been?
I earlier distinguished between short-run and long-run predictability of policy. Fairly strong evidence
supports the conclusion that the short-run predictability of policy has increased in recent years. For
example, Joe Lange, Brian Sack, and William Whitesell (2003) have shown that, since the late 1980s
and early 1990s, monetary policy actions over short horizons have been predicted increasingly well by
financial instruments such as three- and six-month Treasury bills and federal funds futures contracts.
These authors attribute at least part of this improvement to greater transparency on the part of the
Federal Reserve. Poole, Rasche, and Thornton (2002) reach a similar conclusion.5
However, the more important question is whether the Federal Reserve has improved the ability of the
public to forecast its policies at long horizons. Long-horizon forecastability of policy has a number of
dimensions, of course. One that has received particular attention in the literature, and which is closely
related to theoretical models that assume adaptive learning, is the question of whether the public is
able to infer the Federal Reserve's implicit long-run inflation objective.6 Uncertainty about this objective
bears directly on the market's ability to price long-term assets, as well as on the capacity of wage- and
price-setters to strike efficient long-term agreements and of firms and households to make long-term
economic plans.
Various types of evidence bear on this question. For example, some recent research has considered
expectations of inflation and other variables as measured by surveys. One clear finding is that, as
inflation has come under control and has stabilized in the United States in recent years, long-term
inflation expectations have stabilized as well, suggesting reduced uncertainty about the Fed's ultimate
inflation objective. For example, a cross-country study of inflation expectations by staff of the
European Central Bank found that, since 1990, both the average level of expected inflation and the
volatility of reported expectations of inflation in the United States have declined, the latter quite
significantly (especially since 1999).7 However, as an aside, it is interesting that both surveys and the
inflation compensation priced into the yields on indexed bonds suggest that today long-term inflation
expectations in the United States remain in the vicinity of 2-1/2 to 3 percent, above the range of
inflation that many observers believe to represent the FOMC's implicit target. Possibly, this
observation indicates an ongoing process of adaptive learning.
A subtler issue is the degree to which inflation expectations in the United States are anchored.
Specifically, to what extent would inflation expectations rise if actual inflation increased for some
reason? To address this question, Andrew Levin, Fabio Natalucci, and Jeremy Piger (2003) examined
U.S. private-sector forecasts of inflation since 1994. They found that medium- and long-term forecasts
of inflation in the United States are strongly correlated with three-year moving average of lagged
inflation, a finding that suggests that inflation expectations are not entirely anchored but are instead
subject to adaptive learning. As a supporting piece of evidence, Levin, Natalucci, and Piger show that,
compared to other industrial countries, shocks to inflation tend to be relatively persistent in the United
States, an implication of models with adaptive learning.8
Bond markets provide fertile ground in which to search for evidence on the importance of adaptive
learning and the degree to which expectations are well anchored. For example, Refet Gurkaynak,
Brian Sack, and Eric Swanson (2003) show that distant forward rates (e.g., the implied one-year
forward rate ten years in the future) move significantly in response to the unexpected components of
both monetary policy decisions and a number of macroeconomic data releases. Because they do not
find the same result for inflation-indexed securities (that is, real forward rates do not respond to policy
or data surprises), they conclude that long-term expectations of inflation must not be tightly anchored
in the United States. Kevin Kliesen and Frank Schmid (2003) support these findings by showing
directly that ten-year inflation expectations, as derived from inflation-indexed bonds, respond
significantly to policy surprises as well as to the unexpected components of macroeconomic data
releases.9
Interesting work by Sharon Kozicki and Peter Tinsley (2001a, 2001b) bears directly on the importance
of asymmetric information and learning in financial markets. Kozicki and Tinsley incorporate alternative
specifications of the evolution of inflation expectations in a standard model of the term structure (see
Campbell, Lo and MacKinlay, 1997). Kozicki and Tinsley show that by far the best fit is obtained when
inflation expectations are modeled as evolving by adaptive learning, in which inflation expectations
adjust slowly to actual inflation. When inflation expectations are modeled this way, and only when they
are modeled this way, the expectations theory of the term structure performs well and estimated term
premiums are relatively small. In related research, Glenn Rudebusch and Tao Wu (2003) show
empirically that a two-factor model of the term structure can be closely linked to monetary policy
fundamentals, but only on the assumption that the medium-term inflation expectations held by market
participants are time-varying. All the cited findings apply to recent data, as well to earlier observations.
The evidence for asymmetric information and adaptive learning, at least in regard to the Fed's inflation
objective, thus seems quite strong.
Implications for central bank communication
So far I have discussed why central bank communication is important for financial market efficiency
and good macroeconomic performance, and I have presented a few pieces of evidence that suggest
that asymmetry of information between the Federal Reserve and the public may be an important
phenomenon. What implications does all this have for the communication policies of the Fed?
In an ideal world, the Federal Reserve would release to the public a complete specification of its policy
rule, relating the FOMC's target for the federal funds rate to current and expected economic
conditions, as well as its economic models, data, and forecasts. Using this information,
financial-market participants would be able to forecast future values of the policy rate and efficiently
price long-term bonds and other assets. Unfortunately, as stressed by Poole (2003) as well as by
Chairman Greenspan (2003) in his talk at the most recent Jackson Hole conference, specifying a
complete and explicit policy rule, from which the central bank would never deviate under any
circumstances, is impractical. The problem is that the number of contingencies to which policy might
respond is effectively infinite (and, indeed, many are unforeseeable).
While specifying a complete policy rule is infeasible, however, there is much that a central bank can do
- both by its actions and its words - to improve the ability of financial markets to predict monetary
policy actions. With respect to actions, the central bank should behave in as systematic and as
understandable a way as possible, given the macroeconomic and financial environment. That is,
although monetary policy cannot be made by a mechanical rule, policy can and should have "rule-like"
features. Obviously, the more systematic and the more consistent with a few basic principles the
conduct of monetary policy becomes, the easier it will be for the public to understand and predict the
Fed's behavior.10 However, because the world is complex and ever changing, policy actions alone,
without explanation, will never be enough to provide the public with the information it needs to predict
policy actions. Words are also necessary.
What then should the Fed talk about? In general, the research I have discussed today suggests that
the central bank should do what it can to make information symmetric, providing the public to the
extent possible with the same information that the FOMC uses in making its decisions.11 More
specifically, the strongest implication of the adaptive learning literature is that the Fed should be as
explicit as possible about its policy objectives. Without clear information about policy objectives, the
public's problem of predicting future monetary policy actions becomes extremely difficult. For example,
without this information, it would be hard for the public to know whether an unexpected policy move
signals a change in the policymakers' objectives, a change in their economic outlook, or both. As also
suggested by the adaptive learning literature, a potential advantage of having an explicit objective for
inflation in particular is that it may help to anchor the public's expectations.12
Besides its policy objectives, the central bank can make other useful information available to the
public, including its economic forecasts, its assessment of the economic risks, and (if possible) the
models or analytical frameworks that underlie its diagnosis of the economy. The Federal Reserve
currently provides information on each of these elements. For example, the so-called "central
tendency" forecasts of the FOMC are released twice a year, as part of the Chairman's semiannual
testimony before Congress; the statements following FOMC meetings provide some assessment of
the perceived risks to the forecast; and the active research programs conducted at the Board and the
Reserve banks, including publications and conferences, provide observers insights into the underlying
analytical frameworks that inform monetary policymaking.
We should continue to seek improvement in each of these areas. For example, FOMC forecasts might
be released more frequently and for a longer horizon. Additional variables could be forecasted, notably
core inflation, a key factor in FOMC policy decisions. More controversially, the FOMC might consider
forecasting future values of the short-term interest rate, as is currently done by the Reserve Bank of
New Zealand. The difficulty would be to make clear that an interest-rate forecast is not the same as a
policy commitment. The use of "fan charts" to indicate the range of uncertainty would be helpful in this
regard; and indeed, providing more information about the range of uncertainty for all FOMC forecasts
would be a useful innovation.
In my talk today I have often adopted the common convention of speaking of the central bank as if it
were a single actor. In reality, policymaking at most central banks is done by a committee. In the
United States, nineteen people (twelve of whom get to vote at any given meeting) have seats at the
FOMC table. The diversity of views and opinions likely to exist among the members of a large
committee create further challenges for effective communication. However, vehicles do exist to help
convey the breadth of opinion on the Committee. For example, the minutes of FOMC meetings
describe the range of viewpoints and many of the key considerations underlying policy decisions. In
my view, releasing these minutes more promptly than is now done would provide useful and more
timely information for the public. Although at times it feels cacophonous, the willingness of FOMC
members to present their individual perspectives in speeches and other public forums provides the
public with useful information about the diversity of views and the balance of opinion on the
Committee.
Other possibilities for improved transparency may exist. Importantly, as we think about these, we
should not simply take the view that more information is always better. Indeed, irrelevant or badly
communicated information may create more noise than signal; and some types of information
provision - an extreme example would be televising FOMC meetings - risk compromising the integrity
and quality of the policymaking process itself. Rather, the key question should be whether the
additional information will improve the public's understanding of the Fed's objectives, economic
assessments, and analytical framework, thus allowing them to make better inferences about how
monetary policy is likely to respond to future developments in the economy. Communication that
meets this criterion will lead to better monetary policy and better economic performance.