Jean-Claude Trichet: Central banks and the public - the importance of
communication
Text of The Lord Roll Memorial Lecture by Mr Jean-Claude Trichet, President of the
European Central Bank, organised by the Daiwa Anglo-Japanese Foundation, London,
18 November 2008.
* * *
Ladies and gentlemen,
First of all let me express my gratitude for being invited today by the Daiwa Anglo-Japanese
Foundation to give the Lord Roll Memorial Lecture in front of such a distinguished audience.
Throughout his extraordinary life, Lord Roll embodied the classic virtues of an outstanding
international negotiator and a sophisticated economist. He held many influential
appointments at the heart of international affairs - both as a public servant and a merchant
banker. At the same time, Lord Roll was also a remarkably accomplished thinker, a
philanthropist, and - not least - the author of an important book reflecting on two hundred
years of economic thinking. No doubt, he was the rarest incarnation of an applied scientist
who served his country and Europe - he himself was born in the Continent - with dedication
and realism. I am convinced that the intense and far-ranging negotiations of the past days
and months on the future global financial architecture would have undoubtedly benefited
from his exceptional intellectual skills and his experience.
In introducing my remarks this evening, I would like to quote from a report which was drafted
in 1993 by a panel of highly recognised and reputable economic experts - and chaired by the
late Eric Roll - on the occasion of the debate on the political independence of the Bank of
England.1 In the preface of this report, Lord Roll concludes that "[t]he Bank [of England],
specifically charged with the objective of stable money, independent in carrying out this task
accountable
yet within our democratic system for its action, can, we believe, make an
important contribution to the better ordering of our economic affairs". Four years later - in line
with the recommendations of this report - the Bank of England, like many of the world's other
central banks, has been granted full operational independence and nowadays it ranks among
the most transparent central banks in the world.
Why did central banks decide to become transparent?
The Bank of England and virtually all its peers used to communicate very little and with great
caution. Prior to the 1990s, a long-standing conviction in central banking circles held that
monetary policy should be wrapped in mystery.2 The theoretical case for secrecy was
founded on two economic propositions:
•
"successful monetary policy making acts by surprises", and
•
"central banks should try to achieve the benefits of an economy running above or
close to its potential".
The first proposition has been subjected to thorough theoretical scrutiny over the last fifteen
years and is now close to oblivion. The last has been fully discredited in theory and practice.
The old belief - embodied in the first proposition - that monetary policy is made of a
sequence of isolated steps, disconnected from one another and possibly randomised owed a
great part of its theoretical appeal to the notion that rational agents do not suffer from money
illusion. The logic went that if rational individuals effectively adjust their economic behaviours
to insure against money illusion - as indeed they are likely to do over time - then only a
central bank acting by unexpected moves can claim some success in steering economic
conditions.3
But how is "success" measured? Here is where the case for unanticipated policy actions -
and the systematic retention of information that would support this policy - built critically on
the second proposition: that a central bank would measure the effectiveness and success of
its actions by the extent to which economic activity could be raised and maintained above
potential.
Indeed, the time-inconsistency paradigm articulated by Nobel-prize winners Finn Kydland
and Edward Prescott, and applied to central banking by Robert Barro and David Gordon,
offered a positive theory for monetary policy-making by surprises.4 Barro and Gordon
showed that policy makers - under certain institutional conditions - might have an incentive
to exploit the short-run trade-off between inflation and employment. In a world in which
money illusion cannot last for long, such a policy is only viable if the central bank releases no
hints about its objectives, its intentions, and the timing of its actions. It is solely by deviating
from the plan that agents expect to be followed that central banks of this sort can be
successful in stimulating the economy above its limits.
Kydland and Prescott and Barro and Gordon exposed the sub-optimality of such policies at
the same time that they provided a positive theory for monetary surprises and obfuscation.
Once the public recognises the incentives that motivate the monetary authority, they will
adjust their expectations accordingly and unexpected monetary impulses will bear no lasting
effects. In the long run, output will return to its natural level and the economy will suffer from
a permanently higher inflation.
The recognition of the time consistency problem spelled the demise of activist monetary
policies subordinated to short-term objectives. At the same time, it lifted one necessary
condition for considering secrecy the defining and somehow indispensable style of central
bankers.
The drive toward independence provided an additional, positive encouragement for
openness and transparency. In the quarter of a century since the start of the time
inconsistency literature an overwhelming majority of central banks across the globe have
been made independent. The political and functional independence of central banks - now
made immune from political influence - has been an important milestone in the way towards
separating the authority to tax and spend from the power to control credit conditions. This
separation has been the critical factor behind the general decline in trend inflation that we
have observed over the past decades.5 At the same time, the separation has imposed
transparency and frequent communications on the side of the monetary authority as a
manifestation of democratic accountability.
As monetary policy has raised in stature vis-à-vis the fiscal authority - from the ancillary role
to which it was relegated in earlier days - its obligations of democratic reporting have also
increased. But many central banks have gone well beyond strict legal requirements with
respect to both their communication and transparency duties. Why?
Communication about the objective and strategy
Transparency is not only the price monetary authorities had to pay to earn an enhanced
constitutional role as safeguards of macroeconomic stability. It soon became clear that
communication is an instrument to make monetary policy itself more powerful. Once the
inflation bias is eradicated from central bank preferences, wide knowledge of those
preferences can only serve as a coordination device for private beliefs. In a world in which
policy-making by surprises has lost purpose, anchoring expectations around the objectives of
policy help coordinate the reactions of economic behaviours to the macroeconomic shocks
along the appropriate path of adjustment that the central bank wants the economy to follow.
Many central banks have therefore started to communicate their firm commitment to a
nominal anchor, through the announcement of a precise arithmetic definition of price stability.
In many cases, central banks have gone further in their quest for openness and have spelled
out a more general monetary policy strategy, and the analytical framework that is used by
policy makers to assess the risks to the achievement of the central bank's objectives.
Communication about the objective helps nail down the steady state of the economy, the end
point to which the economy spontaneously tends after shocks fade. Communication about
the strategy helps explain the way monetary policy behaves outside the steady state, how it
responds to shocks and frictions to facilitate the economic convergence back to steady state.
Communicating about the principles that govern the strategy makes the process of
adjustment more rapid and less painful.
A growing body of empirical evidence supports the conjecture that transparent quantitative
objectives and communication about the strategy reinforces monetary policy. Empirical
findings confirm that a precise definition of price stability, or the announcement of an inflation
target, lowers inflation expectations, helps to anchor them at levels consistent with the
central bank's preferences and reduces the sensitivity of inflation expectations to past
inflation and other macroeconomic news.6
The anchoring power of a quantitative objective is indeed remarkable. A recent ECB study
has shown that, following the introduction of a quantitative definition of price stability, inflation
persistence - defined as the tendency for inflation to deviate from its mean following a shock,
rather than quickly reverting to it - has essentially disappeared in the euro area, in
Switzerland and in five inflation-targeting countries.7 While a large component of the switch
in expectations formation is due to the genuine regime change, the exceptional speed of the
adjustment would not have been possible without extensive communication about the onset
of a new regime.
Financial market data - a more elastic, if sometimes noisy indicator of public perceptions
than survey data - confirms the existence of a link between communication about the
ultimate objectives of policy and expectations. Both a Fed Board case study on the United
Kingdom and Sweden, and an ECB study on the euro area show that market-based inflation
expectations for these countries are generally unresponsive to macroeconomic news, a sign
that they tend to remain unperturbed when the economic environment changes.8
Communication about actions and prospects
The adoption of a clear and deliberate monetary policy strategy has added two further
dimensions to communication: the announcement and explanation of monetary policy
decisions when these are made, and the regular exposition of the central bank's assessment
of the current economic situation and its most likely evolution.
In the absence of frequent disclosures about policy and the economic situation, market
participants may not be in a position to attribute fluctuations in inflation either to exogenous
disturbances outside the control of the central bank or to changes in policy intentions.
Adverse adjustments in expectations could lead to an increase in inflation today and to a
slower and more painful reversal later in the process.9
A central bank has two instruments in these situations, which are not substitutes, but rather
complement each other. It can react to misconceptions once they manifest themselves, by
enacting a particularly strong response to the threats that they pose. As inflation tends to
persist once it is set in motion, the policy response might need to be sizeable and disruptive.
In the "old world" in which central banks minimised their pronouncements and made no
efforts to disclose their views on an ongoing basis, this reactive and demonstrative pattern of
monetary policy response was indeed the only option open. It is difficult not to associate the
systematic disconnect between the views entertained by the policy-makers and the
information set accessible to the public that prevailed in the old days with the recurrent
pattern of stop-go episodes that plagued the monetary policy history of the 1970s.
In the new regime, in which policy-makers are dedicated to being open and transparent,
communication channels offer some more lines of defence in the face of such situations.
Providing the economic interpretation of the situation, the judgement and economic thinking
around it, and the central bank's assessment of future directions can correct faulty
at
expectations source. This can minimise the risk that inaccurate forecasts might induce
misallocations of resources and derail the economic course.
Communication does not substitute for action. But it can help fill the information gap on which
the need for action is sometimes predicated.
The ECB's approach to communication and its efficacy
Communication is a constituent part of the institutional design for monetary policy and needs
to be styled according to the principles and constraints that shape those institutions. There
are recognizable differences in the ways central banks communicate to their publics. These
differences are not accidental: they can be traced to the economic, political and institutional
factors that face individual central banks.
The ECB is no exception and it has elaborated its own communication framework. Since the
very start in October 1998, the ECB has announced its monetary policy strategy - a
quantitative definition of price stability and a two-pillar, medium-term orientated analytical
framework, comprising of an economic and monetary analysis for the assessment of risks to
price stability. In doing so, it laid the foundations for a high degree of credibility and
emphasised its commitment to being open and transparent. In particular, by formulating and
publishing a quantitative definition of price stability - below, but close to 2% - the ECB has
provided the basis for the public to form expectations efficiently and to reduce the sensitivity
of inflation expectations to short-term shocks.
The decision has paid off. Long-term inflation expectations for the euro area, as - for
example - compiled by Consensus Economics Forecast, have remained in a range between
1.7 and 2 per cent since the introduction of the euro in 1999. Inflation expectations as
derived from financial markets were more volatile over the same period and even though - at
times - they showed weak signs of divergence from our definition of price stability - as for
example during the recent period of strong increases in food and energy prices - we
succeeded in rapidly regaining control over inflation expectations due to our open and strong
commitment to the achievement of our primary objective. Similarly, recent empirical findings
show that longer-term inflation expectations in the euro area are to a large extent
unresponsive to developments in actual inflation outcomes, further pointing to a solid
anchoring of inflation expectations at levels consistent with our definition of price stability.
This is an important achievement, in particular against the background of the numerous
adverse supply-side shocks that hit the euro area over the past years. At the same time, the
quantitative definition provides a clear yardstick to be compared to the observed inflation by
all observers and market participants and against which our fellow citizens can hold the ECB
accountable.
Despite the extraordinary role of the ECB's strategic framework in our communication policy,
in a world of uncertainty with incomplete information on the state of and prospects for the
economy, genuine understanding of our strategy is a necessary, albeit insufficient, condition
for the public to form pertinent expectations regarding the future course of monetary policy.
Discrepancies between the expectations of the private sector and those of the central bank
may emerge at any point in time because of differences in the interpretation and assessment
of the state of the economy and the associated policy reactions. The ECB therefore makes
considerable efforts to explain the economic rationale underlying monetary policy decisions
by providing detailed and comprehensive analyses of the current economic and monetary
conditions and of the Governing Council's assessment of the medium and longer-term risks
to price stability on the basis of our strategy. The challenge in this type of communication is
to strike the right balance between the need to provide guidance to the markets while
preserving the flexibility to always re-assess the appropriateness of the monetary policy
stance in the light of changing circumstances and to never pre-commit to a medium term
sequence of future interest rates.
The introductory statement at the monthly press conference after the first Governing Council
meeting in each month is an important vehicle of our communication in this respect. It
explains in depth the monetary policy decisions taken, it is structured along the lines of our
strategy and it conveys the collective view of the Governing Council on the monetary policy
stance. The information conveyed in this way is therefore - in essence - similar to what other
central banks publish in "summary minutes". The ECB practice - however - has the two key
advantages of offering better timeliness and more flexibility as compared to the disclosure of
collegial minutes, while - at the same time - we reach out to a broader audience. In
particular, the press conference not only provides detailed information on our policy
deliberations at a much earlier time than minutes - the press conference takes place 45
minutes after the decision on the key interest rates has been announced in a press release -
but it also offers the media an opportunity to address a variety of issues in a direct, open and
totally unfiltered manner. The extent of our press conference - that, at times, can last for an
hour or more - is a lucid reflection of the need and demand for an open and frank exchange
of views between policy-makers on the one side and representatives of the media on the
other.
The decision of the Governing Council not to publish voting records has been made to stress
the collegial nature of the ECB's decision-making process and the specific institutional
circumstances under which the ECB operates as a supranational institution. Publishing
information on the individual voting behaviour would entail the risk that the votes of
Governing Council members - and in particular of the Governors of National Central Banks -
might be interpreted from a "national" perspective, irrespective of their genuine underlying
rationale. This could jeopardise the credibility of our decisions and undermine the area-wide
perspective that we unanimously internalise in our meetings.
The importance of the ECB's press conference as a relevant source of policy-related
information can be gauged by its real-time effect on financial markets. The ECB's case
provides a particularly interesting opportunity to extract the different signals of central bank
communication, as unlike other central banks that release their decisions and explanatory
statements simultaneously, there is a short time difference between the release of the
decision and the underlying explanation delivered at the press conference. Changes in
forward rates during the press conference can therefore only be due to news related to the
future path of short-term interest rates and cannot be contaminated by news relating to the
announcement of the policy decision. A recent ECB study shows that there has been not
only a general reduction in market reactions on Governing Council meeting days over time,
but that the small remaining reactions relate much less to the surprise component for any
given decision and much more to the surrounding communication and its implications for the
future path of interest rates.10 In a similar vein, a related research study finds that the ECB's
press conferences have - on average - larger effects on asset prices than do
announcements of policy decisions.11 At the same time, these larger effects on interest rates
are accompanied by smaller effects on the volatility of asset prices, indicating that the signal
to noise ratio of the press conference is high. This is not a surprising result at all. In fact, the
Q&A session allows journalists to pose clarifying questions and provides them with the
opportunity to digest the information provided.
Accurate communication has yielded high predictability. There is compelling empirical
evidence indicating that the ability of financial market participants to correctly anticipate the
next monetary policy decision is - both in absolute terms and relative to other central banks
- remarkably high.12 For instance, out of a total of 153 days on which Governing Council
meetings were held from 1999 to October 2008, financial markets were surprised -
according to a common definition of the surprise element in this literature - on only eight
occasions. The last surprise occurred in March 2003 when markets had actually perfectly
anticipated that we would decrease our main policy rates, but they were rather surprised
about the size of the change, which was smaller than expected at that time. Market
participants appear to have been able gradually to converge to a thorough understanding of
the ECB's monetary policy framework and communication mode. Similar results on the
degree of short-term predictability were found by a recent survey conducted by Barclays
Capital among financial market participants. A sizeable majority of survey participants - 60%
- felt either "very confident" or "confident" in the way they were able to anticipate policy
decisions by the ECB.
For a supra-national institution such as the ECB, speeches are a particularly important
communication tool as they allow the Governing Council members to convey the view of the
Council in their own languages, thereby overcoming potential cultural, linguistic or other
national barriers of communication and bringing our policy closer to the people. The delivery
of speeches by policy-makers is an opportunity for the public to test whether the
policymaking committee is a truly collegial body, rather than a collection of individuals, and
whether its members share a sense of common ownership of decisions. The principle of
speaking with a "single voice", to which the members of the Governing Council adhere when
talking publicly is meant to ensure that the views expressed individually always convey those
of the Council as a whole. This policy is a manifestation of our collective responsibility; it
raises the clarity of our message and has - according to the empirical literature - efficiently
reduced the potential "noise" in our communication. The importance of this policy will
certainly increase as the euro area expands. In this respect, an ECB study shows that a
higher degree of communication dispersion among committee members about the conduct of
monetary policy lessens the ability of financial markets to anticipate future monetary policy
decisions and raises the degree of uncertainty.13
Communication in difficult times
Quoting from Alan Blinder, "perhaps the best a central bank can do is to teach the markets
its way of thinking."14 This didactical role of central bank communication - if supported by an
established strategy - is often a quiet and uneventful activity. As I mentioned, the strategy
and the founding principles of monetary policy largely take care of aligning the "transmitter"
and the "receiver" and make the broadcast a reassuring repetition of known facts and
principles.
In difficult times, however, when the economic outlook darkens exceptionally and confidence
falters, communication becomes even more important to explain how the central bank
intends to control the inevitable trade-off that such testing circumstances pose: the need to
take swift action - on the one hand - and the need to communicate the complete adherence
to its long-term objectives and the way it intends to steer the policy course back to a normal
path once those circumstances have subsided.
The resolution of this trade-off is inherently challenging for all central banks. However, it is
facilitated by two fundamental components of the ECB's monetary policy strategy.
The first is the quantification of a price stability objective. This grants predictability even in the
absence of explicit communication about the future path of policy. Agents can draw inference
about the most likely direction of policy by comparing the most likely evolution of inflation -
which is part of the information that the ECB conveys to the market - with the objective of the
ECB.
The second component of the strategy which helps in times when expectations become
disoriented is the agility of action in the management of the money market combined with a
measured, medium-term oriented approach to the reassessment of the stance. The latter
ensures that the ECB keeps - and communicates - a sense of direction when markets are
gripped by a sudden loss of confidence. The former reassures markets that any temporary
disfunctionalities in the way markets work will not impede the transmission of the ECB's
monetary policy intentions to the economy.
The two components of the strategy have afforded the ECB a flexible management of its
operational instruments and procedures in the midst of extreme conditions, most notably
during the recent turmoil in global financial markets. They have allowed a robust supporting
role for solvent banks while at the same time preserving the long-term focus on price
stability.
When the risks to our financial system - which we had repeatedly highlighted in open
communication - materialised last summer and threatened to impair the orderly functioning
of the euro money market, two messages had to be clearly conveyed. One was that the ECB
was determined - from the onset of the financial crises in August 2007 - to ensure the
orderly functioning of the euro area interbank money market by offering supplementary
liquidity-providing refinancing operations or - more recently - by widening the collateral
framework to facilitate the provision of liquidity to merchant banks and to engage in unlimited
provision of liquidity for all our refinancing operations at a fixed rate.
The other message was to raise the public's awareness that the exceptional interventions
aimed to alleviate the tensions in the money market would not compromise in any respect
the longer-term achievement of the price stability objective and that the ECB would not
tolerate or encourage imprudent behaviour by market participants.
Conclusions
Let me conclude. The fundamental changes in central bank communication have helped to
enhance the effectiveness, predictability and credibility of monetary policy and have notably
contributed to lowering both inflation rates and volatility in the real economy. For its part, the
ECB has established a practise of making its policy transparent and in setting new
benchmarks in the area of central banking communication. That being said, in each
occasion, a central bank has to carefully assess the relevance, clarity and timeliness of the
information as ill-designed communication has the power to harm the economy.
Transparency is a key ingredient of an effective monetary policy, but not an end in itself.
Communication is an ongoing challenge and effective communication will always be
characterised by a high degree of flexibility and adaptability in order to respond swiftly to a
rapidly changing economic environment.