Charles I Plosser: Communication and transparency in the conduct of
monetary policy
Speech by Mr Charles I Plosser, President and Chief Executive Officer of the Federal
Reserve Bank of Philadelphia, at the Council on Foreign Relations, New York City, 8 May
2014.
* * *
The views expressed are my own and not necessarily those of the Federal Reserve System or the FOMC.
Highlights
1. President Plosser outlines his views that policy transparency and forward guidance
could be enhanced if the central bank would be more explicit about its reaction
function.
2. President Plosser notes that one way to be more explicit would be to indicate the
likely behavior of the policy rate based on a few different Taylor-like rules that have
been consistent with past conduct of monetary policy and are robust to our
uncertainties regarding the true economic model.
3. President Plosser believes that the Federal Reserve Board staff's model, called
FRB/US, seems to be a reasonable starting point for providing economic forecasts
based on those rule-based policies.
Introduction
Thank you for the kind introduction. It's a pleasure to return to the Council on Foreign
Relations. I know that the value of these sessions often arises during the discussion, so I will
try to keep my opening remarks brief. Before I go any further, though, I should begin with the
usual disclaimer that my views are my own and do not necessarily reflect those of the
Federal Reserve System or my colleagues on the Federal Open Market Committee.
The topic I want to address today is communication and transparency in the conduct of
monetary policy. Some of you can recall when it was taken for granted that the central bank
was supposed to be secretive and mysterious. The guiding principle was simple: The less
said about monetary policy, the better. Indeed, it was not until 1994 that the Federal Open
Market Committee (FOMC) began to announce policy changes made at its meetings.
But times have changed. Transparency has replaced secrecy, and open communication has
replaced mystery. The extent of this transformation is, in many ways, remarkable. Today, the
issues of communication and transparency are front and center on the agenda of many
meetings and conferences on central banking. A major reason for the focus on these issues
is the recognition that the stance of monetary policy encompasses not just the current level
of the short-term policy rate but its expected future path as well. More broadly, economists
have come to understand that expectations, including expectations about monetary policy,
play an important role in determining economic outcomes, such as real economic growth and
inflation.
One element of communication that has received a good deal of attention is forward
guidance. Forward guidance is central bankers' speak for communication about the future
course of monetary policy, and particularly about the likely path of the short-term policy rate.
One reason for this increased attention on the future path of policy is that short-term rates
have been constrained by the zero lower bound. So when, or under what conditions, the
nominal policy rate might eventually rise takes on greater significance.
However, forward guidance is not a separate or independent tool of policy. Its effectiveness
is intimately related to other features of monetary policy. In particular, a credible, systematic
approach to policy and the general openness and transparency of the policy process are
essential elements in shaping expectations. Even with this recognition, there are various
views about how best to communicate information about the intended path of policy and how
to ensure that such information is credible. If it is not credible, then it will not shape
expectations in a beneficial way.
More generally, a central bank can and often does communicate on a host of important
issues, including its view of the current state of the economy, its assessment of risks, and its
outlook for key economic variables. Perhaps most important, from my perspective, is
communication about how the evolution of key economic variables systematically shapes
current and future policy decisions.
In my remarks this morning, I want to stress the importance of the FOMC articulating such a
systematic approach to policy. Doing so is likely to make forward guidance more effective, by
helping the public to better interpret what that guidance means.
The benefits of systematic monetary policy
So what do I mean by a systematic approach to policy? Quite simply, I mean conducting
policy in a more rule-like manner. The antithesis of such rule-like behavior, of course, is
discretion; that is, policymaking conducted period by period with great latitude to take
whatever actions seem best at the time.
The rules-versus-discretion debate in economics is an old one, dating back at least to Henry
Simons in 1936.1 Yet, following the Nobel Prize-winning work of Finn Kydland and Ed
Prescott in 1977, most academic economists - but, unfortunately, far fewer policymakers -
have come to accept the benefits of adhering to rule-like behavior in monetary policy.2 These
benefits arise, in part, because consumers and businesses are forward looking, and credible
commitments concerning the determinants of the future path of policy can alter expectations
in ways that make policy more effective and less uncertain. The ability to behave
systematically and to align the public's expectations with that systematic behavior can allow
the central bank to increase current economic activity, while simultaneously lowering
inflation. But a credible commitment to honor past promises is an essential element of
rulelike policy. Discretionary decision-making undermines such commitments.
The appropriate way to make policy systematic, or rule-like, is to base policy decisions on the
state of the economy. That is, policymakers should describe the reaction function that
determines how the current and future policy rate will be set depending on the state of the
economy. Policymakers are, of course, no more certain about future economic conditions
than anyone else is, and therefore cannot realistically commit to particular future values of
the policy rate. Nonetheless, describing a reaction function or rule that explains how the
policy rate will be determined in the future as a function of economic conditions can be highly
informative.
Unfortunately, the science of monetary policy has not reached the point where we can
specify a rule for setting policy and turn decision-making over to a computer. Judgment is still
required. Nevertheless, I place a great deal of importance on systematic behavior both as
prescription for good policy and in terms of my own policy deliberations.
Much study has been done on various rules, but the most well-known rule is attributable to
John Taylor.3 The Taylor rule is a reaction function that indicates how to set the policy rate as
a function of deviations of inflation from the inflation target and some measure of economic
slack.
The attractiveness of Taylor-like rules for monetary policy goes beyond their intuitive appeal
or the fact that they seem to describe the actual behavior of monetary policy reasonably well.
The reality is that Taylor-like rules yield very good results in a variety of theoretical settings.
While this is surprising to some, it is of enormous practical importance. Given our uncertainty
about the true model of the economy, knowing that systematic policy in the form of a
Taylorlike rule delivers good outcomes in a variety of models means that these simple, robust rules
can provide useful guidance for policy.
Systematic policies that provide important information about the policymakers' reaction
function combined with other information, such as the policymakers' economic forecasts, can
sharpen forward guidance in a way that reduces policy uncertainty and enhances economic
performance. Thus, well-designed communications are valuable, and behaving
systematically has the added advantage of making those communications easier for the
public to understand.
Increasing transparency
But what else should the central bank convey? For example, should it publish forecasts of
variables in its policy reaction function and should these forecasts be based on the most
likely path that the policy rate will follow or on some other assumption?
While many central banks publish forecasts in detailed inflation or monetary policy reports,
there is still debate about the nature of the forecasts and the assumptions that underlie them.
For example, who owns the forecast? At some central banks, the forecast is that of the policy
committee and thus represents a type of consensus forecast. In other cases, the forecast is
that of the central bank staff. Individual policymakers who do not fully buy into the forecast
are then free to express their own independent views about the outlook.
A critical piece of a forecast emanating from the central bank is the nature of the future path
of the policy rate. Should a central bank's published forecast be based on its assessment of
what the policy rate path is likely to be, perhaps based on its reaction function, a so-called
unconditional forecast? Or should the forecast be based on an interest rate path that is more
arbitrary, such as a constant interest rate path or one that is related to market expectations
inferred from forward interest rates. Others question whether the central bank should reveal
the forecast's assumed interest rate path at all.
Perhaps the greatest fear preventing most central banks from publishing the best
assessment of its future interest rate path is that the public will assume the projections will be
taken as a commitment to that path rather than a projection influenced by the evolution of the
economy. In my view, such fears could be mitigated if policymakers would articulate the way
they systematically expect to adjust policy in response to changes in economic conditions.
While I have suggested potential problems if the central bank publishes its assessment of the
likely near-term path of policy rates, in conjunction with its economic forecast, there is also a
major benefit; namely, the added discipline that it places on the policy process itself. As I
alluded to in my introduction, monetary policy does not just affect the economy through the
current setting of the interest rate, but also through the expected path that the policy rate will
take over time. Providing information about how that path is likely to evolve forces
policymakers to think more deeply and systematically about policy. Communication about
that path, in turn, gives the public a much deeper understanding of the analytical approach
that guides monetary policy. Again, my view is that policy transparency and forward guidance
could be enhanced if the central bank was more explicit in articulating its systematic
approach to policy.
Conclusions and going forward
I am fully aware that great care needs to be taken in providing more specific forms of forward
guidance so that we avoid a false sense of certainty and a mistaken sense of commitment.
Yet I believe systematic monetary policymaking can enhance economic performance, and
therefore I favor clearer communication concerning the formulation of policy.
In a stylized world, where there is a single monetary policymaker who has considerable
confidence in a model of the economy, effective communication would include a forecast
derived from this model. This forecast would incorporate a policy path that yields the best
economic outcomes based on that single policymaker's views.
However, we don't live in such a simple world. Monetary policymaking is often conducted by
committee, and divergent views can and often do exist. While this can be clumsy at times,
such governance mechanisms have great strength in preventing institutions from lapsing into
groupthink by ensuring that various views are heard in an environment that promotes better
decisions and outcomes and helps to preserve central bank independence and
accountability.
Thus, it may be difficult for the FOMC to achieve a consensus forecast or policy path. One
way to enhance its communication would be to indicate the likely behavior of interest rates
based on a few different Taylor-like rules that have been consistent with the conduct of
monetary policy. Doing so would require agreement on a particular model in order to produce
the resulting rule-based behavior. For the Fed, the Board staff's economic model, called
FRB/US, seems like a reasonable place to start. The FOMC could then articulate whether
and why it anticipates policy to be somewhat more restrained or more accommodative
relative to the projections given by the rules. A monetary policy report that might accompany
such a forecast could include various views that may differ from the baseline summaries.
Performing this exercise would indicate the inherent uncertainty that policymakers face, yet it
would also provide a better sense of the likely direction of policy and the variables most
related systematically to that policy. Further, this type of communication would push the
FOMC to conduct policy in a more systematic manner, which I believe will lead to better
economic outcomes over the longer run.