The Lighter Side of Making Monetary Policy1
I am honoured to be invited to this year's Conclave. In a short span of
eight years, the SBI Banking and Economics Conclave has emerged as
an important platform of eminence and relevance for deliberating on
issues shaping the banking system and more broadly, India's financial
sector. This year, the backdrop is a daunting one.
Across the world, monetary policy authorities are engaged in the most
aggressive and synchronized tightening in decades. They are resolute in
their determination to put the genie of inflation back into the bottle. '75' is
the new '25'. Their stances and forward guidance sound like the shrill calls
of birds of prey. Financial markets are awash with surges of volatility -
incoming data trigger either risk-off stampedes or relief rallies. Globally, a
widespread fear is that the forceful monetary policy tightening will
precipitate a hard landing, i.e., a recession, or several of them.
Geopolitical strife with no end in sight, centrifugal forces threatening to
tear apart the unifying influence of global integration, and financial
fragmentation are the new forces that seem to be chiseling the evolving
global economic outlook.
I thought that I would take this opportunity to step back from the heat and
flying debris now being associated with the outcomes of monetary policy
actions. Instead, I propose to slip backstage and peer into what goes on
underneath these outcomes. Perhaps, this may help to understand the
outcomes a little better. Perhaps, it will enable a more compassionate
view of the people involved in the making of monetary policy, their trials
and tribulations.
Monetary policy is by its nature a technical area of economic policy
making. It is suffused with substantial inherent uncertainty. This
uncertainty created primarily by the need for policy makers to guess the
future2. Monetary policy has to be forward-looking because of the lags
with which a policy rates change get transmitted across the markets and
eventually gets reflected in lending rates, mortgage rates and yields.
Hence monetary policy can only hope to address future inflation, not
today's inflation. It is often viewed as a specialist or niche subject, only
intelligible to specialists. My own experience with soiling my hands is that
all this is overstated. Undoubtedly, monetary policy makers today are
treated like film stars. The public is constantly trying to second guess their
likely moves. For this purpose, analysts pore over millions of data points
in search of patterns of behaviour. They try to construct reduced-form
explanations of monetary policy decisions - a polite expression for
equations and statistical models - and attempt predictions on the basis of
these regularities. In fact, the monetary policy reaction function - an
equation which tries to predict the change in the policy rate if inflation
deviates from the target and/or growth deviates from its trend - has
spawned a cottage industry. But what is forgotten is that these regularities
are based on past data and in that sense, they may provide an ex post3
explanation of why policy makers deviated from a so-called rule or why
they did not. They are not ex ante predictions of policy decisions because
at the core of the decision is uncertainty and therefore, intelligent and well-
informed judgement is called for - the celebrated smell test4.
As regards forecasts, monetary policy makers were created to make
weather forecasters look good, to draw on an analogy on economists. In
fact, it is said that monetary policy makers do have a sense of humour -
that is why they put a decimal point on their forecasts5.
Yet, monetary policy makers are after all human beings, and humans
bring with them humour in whatever they do. They laugh at each other,
they laugh at themselves, and one reason cited for this - which I will deal
with presently - is stress-busting. The theme of my talk is the humour that
is an integral part of monetary policy making. This has not received
attention either among economists or among the lay public. My purpose
is to show you that if you allow humour into the conversation, you might
end up understanding monetary policy, its objectives, decision making
processes, forecasts and communication a little better. You might also
end up thinking of monetary policy makers as humane as they dabble with
macro-aggregates and the unforeseen future.
4
Robert Solow, 2010, Testimony to the House Committee on Science and Technology
Subcommittee on Investigations and Oversight "Building a Science of Economics for
the Real World" July 20, 2010: "I do not think that the currently popular DSGE models
pass the smell test. The protagonists of this idea make a claim to respectability by
asserting that it is founded on what we know about microeconomic behavior, but I think
that this claim is generally phony. The advocates no doubt believe what they say, but
they seem to have stopped sniffing or to have lost their sense of smell altogether."
5
https://fpw.usu.edu/index.php/2017/01/09/why-did-god-create-economists-to-makeweather-forecasters-look-good/ and
https://livestream.com/accounts/5208398/events/6729795/videos/145963063
Or you might not. In April 2006, a panel of distinguished economists6 was
asked to discuss the linkages between monetary policy and the
personality of the nation's central bankers. Remember: central bankers
studiously practice an appearance of drab dullness which, they believe,
conveys a sense of monetary stability. The specific question the panel
was asked was: "What if the leader of the central bank told hilarious jokes
and did card tricks?" I am not bluffing: there is a paper by this specific title
in the American Journal of Economics and Sociology7 which I highly
recommend for your reading.
The panel was not amused. One of the members concluded that
demeanor has no role to play in the practice of central banking aimed at
delivering price stability. Another opined that in the world of central
banking and its interface with financial markets, opacity has value. A third
member was of the view that central bankers should uphold a solid
reputation for sobriety. In fact, rare instances of laughter reported in
FOMC transcripts. In one influential view, they have been criticized as
showing 'an incredible amount of complacency, with people mainly
worried about inflation rather than the coming recession8. More on this
later.
6
Dr. George Tavlas, Head of the Economic Research Department, Bank of Greece;
Professor Perry Mehrling, Columbia University, USA; Professor Jocylyn Pixley,
University of New South Wales, Australia and Professor Laurence S. Moss, Babson
College and then editor of AJES.
7
Mehrling. P., Laurence S. Moss, Jocylyn Pixley and George S. Tavlas, (2007), "What
if the Leader of the Central Bank Told Hilarious Jokes and Did Card Tricks? A Panel
of Experts", The American Journal of Economics and Sociology (AJES), Vol.66, No.
5, November.
8
Krugman, P. (2012), "Bubble Memories." The Conscience of a Liberal,
http://krugman.blogs.nytimes.com/2012/01/13/bubble-memories-2/
The Metamorphosis of Central Banking
Much of this ambivalence about monetary policy is due to the fact that the
world of central banking has changed dramatically over the years.
Monetary policy used to be a dark art, practised by magicians, and
wrapped in secrecy9. During the days of the gold standard, central
bankers were considered high priests of the temple of money. In its
innermost sanctum sanctorum, they were believed to perform alchemy by
which base metals like lead could be transformed into noble metals such
as gold. Mervyn King, Governor of the Bank of England from 2003-2013,
writes that when he joined the Bank of England in 1991, he was fortunate
to be invited to dine with a group that included Paul Volcker (the champion
among central bankers). At the end of the evening, he asked Paul Volcker
for any advice for a new central banker. Volcker replied in one word:
"mystique" (King, 2000). That single word encapsulated much of the
tradition and wisdom of central banking at that time.
Why were they so opaque, so ambiguous? For years, central bankers
were an endangered species. Maintaining a low profile and passing the
blame elsewhere were central bankers' survival toolkits. The story is told
of a Chairman of the US Fed who made a courtesy call on his predecessor
before taking up office. The predecessor handed the new Chairman three
envelopes with the advice that whenever he found himself in trouble at
work, he should open the envelopes but one at a time. Each would have
advice on what to do. When the new Chairman found himself under attack,
he opened the first envelope. It said: "Blame me". So, the new Chairman
blamed the predecessor. After some time, the new Chairman came under
attack again. He opened the second envelope. It said: "Blame the
government." So he did that. After some more time passed, he came
under attack again. So he opened the third envelope. It said: "prepare
three envelopes." On a serious note, the mainstream view of the 1960s is
encapsulated in this remark by Gardner Ackley, then Chairman of the
Council of Advisors under Lyndon Johnson, the 36th president of the US:
"I would do everything I could to reduce or eliminate the independence of
the Federal Reserve"10. Today, all that is changed. Governments uphold
the independence of the central bank.
Goals of Monetary Policy
Just before the pandemic and the war in Ukraine struck within a span of
two years, the world was heralding the success of inflation targeting.
Long-term inflation expectations were firmly anchored to targets; the
flattening of the Phillips curve was an indication of the reduction in the
variability of prices; and exchange rate passthrough to inflation was
diminishing, de-emphasising the role of imported inflation. In spite of the
global financial crisis (GFC), global inflation barely budged11. Some even
regarded the GFC as a failure of inflation targeting because of its success
- by ensuring low and stable prices of goods and services, arbitrage
opportunities shifted to financial asset prices, causing the GFC. Today,
inflation is at levels not seen in four decades, impervious to aggressive
and front-loaded monetary policy tightening across the world. The
existential question being asked is whether the world is permanently
shifting from a low inflation environment to a high inflation one. The time
has come to review the objectives of monetary policy.
Walter Bagehot's central bank had one objective: "lending freely against
good collateral at a penalty rate"12. Being the lender of the last resort was
its only function so as to avert financial panics and confidence runs. Thus,
central banks came into existence to secure and preserve financial
stability. Scratch a central banker and underneath the skin, this age-old
commitment to financial stability is always revealed.
The goal of price stability is essentially born out of the Great Inflation of
the 1970s. It emerges from that experience or at least from an
interpretation of it that low inflation maximises welfare because it is a
necessary condition for sustained growth, and that dedicated institutions
like the central bank can achieve that goal if they are allowed to operate
free of pressure groups and vested interests. By the 1990s, numerical
targets were being assigned to the inflation objective.
Yet, it is well known among economists and monetary policy makers, at
least today, that on its own, monetary policy cannot influence the long-run
growth of the economy, the so-called long-run neutrality of money.
Monetary policy can at best create congenial conditions for other policies
to influence the growth rate. Yet, almost every central bank has a dual
12
Lombard Street: A Description of the Money Market, 1873 is regarded as among
the earliest writings on central banking, "A panic, in a word, is a species of neuralgia,
and according to the rules of science you must not starve it. The holders of the cash
reserve must be ready not only to keep it for their own liabilities, but to advance it most
freely for the liabilities of others. They must lend to merchants, to minor bankers, to
'this man and that man,' whenever the security is good. In wild periods of alarm, one
failure makes many, and the best way to prevent the derivative failures is to arrest the
primary failure which causes them".
mandate - growth/employment objective is always tagged on despite all
the arguments to the contrary that I alluded to earlier. Is this growth
objective reflecting the age-old mandate of financial stability? Naturally,
numerical targets for the growth objective are not generally assigned.
What do the economists say, since their tribe so densely populates the
monetary policy space? Unfortunately, they speak as always in several
tongues. Up to the 1970s, the dominant Keynesian revolution and its
mutations upheld an empirical regularity discovered in 1958 between
wages and unemployment - the Phillips curve13. By raising wages,
employment and hence GDP can be increased, but the wage increase
causes inflation to rise. Soon wage earners realise that the increase in
wages has been eroded by inflation. So they demand even higher wages.
A wage-price spiral sets in that starts eating away at profit margins.
Producers realise that there is no point in expanding production with
losses. So, eventually, GDP slows and contracts. Yet, central banks of
that time played a game with the economy. They were willing to trade a
little more inflation for a little less unemployment (little higher growth) by
printing money, hoping to fool other economic agents. The disastrous
experience of the 1970s showed that it was a game in which everyone
lost. Today central bankers have stopped playing that game. Be that as it
may, this brought to the fore the views of another set of economists - the
Chicago school, prominently represented by Milton Friedman and Robert
Lucas Jr. - which argued that you can't fool the public through
misinformation about the short run Philips Curve. Less unemployment
(higher growth) today will inevitably result in higher inflation later and
higher unemployment (lower growth) down the line. Monetary policy
should play a passive, rule-based role and avoid unpleasant monetary
surprises of trying to squeeze out a little higher growth by tolerating higher
inflation.
As I stated earlier, there is no point turning to economists for advice. Their
answers are going to be as ambiguous as the uncertainty that
characteries the conduct of monetary policy. It is said that there are two
fundamental laws of economics. The first law is: for every economist,
there exists an equal and opposite economist. The second law: they are
both wrong. Perhaps the dual mandate of monetary policy is intended to
keep this two-handed tribe busy.
Even if the dual mandate is taken as fait accompli, let us evaluate its
operational feasibility. At any point in time, the goal variables of inflation
and growth are not visible to the monetary policy maker - inflation data
are at least one month old, and those on GDP are at least three months
old. Forecasts can be made in to the future, but they are based on
backward looking information of one to three months ago, as I explained
earlier, and they can be thrown off course by unanticipated shocks that hit
them in the future. Furthermore, the goal variables are moving over time
and so monetary policy maker has to take in to account not their known
positions but their uncertain future trajectory. Then they have to shoot
forward - getting the angle right is crucial to taking the shot. In this
challenging situation, monetary policy makers sift through an ocean of
information - high frequency indicators; forward looking surveys;
expectations of market participants, professional forecasters and
analysts; econometric models; sentiment analysis based on artificial
intelligence and machine learning techniques; all as a part of trying to
guess the likely future path of the goal variables. Essentially, it is like
monitoring a radar screen and using accumulated knowledge to
distinguish between friendly configurations and hostile formations. This is
then fed into setting the trajectory of the instruments so that the probability
of hitting the moving goal variable is maximized, though success is far
from assured. If they succeed, it is treated as business as usual and it
goes unnoticed; if they fail, they are censured and burnt at the stakes.
A further complexity added to their tightrope walking is that goal variables
are subject to revisions between the release of first advance estimates to
provisional estimates to revised estimates to final accounts.
Consequently, the monetary policy decision, which is taken at the time of
the receipt of the first data release, become questionable about its
integrity because of frequent revisions. In this context, a remark made by
Ben Bernanke in the FOMC and reported in published transcripts is
sobering: "I have a modest proposal, which is that if the BEA (US Bureau
of Economic Analysis) can restate GDP figures and if firms can restate
their earnings then the FED should have the option to go back and restate
interest rates from last time (last meeting of the FOMC) [laughter]"14.
Please note the word 'laughter' in square brackets. It is the manner in
which the FMOC transcripts indicate the elicitation of humor during
discussions in its meetings. I will address this issue in some detail
presently.
The Decision
Today the world over, the monetary policy decision is taken by a
committee of appointed officials. Deliberations among committee
members leads up to a vote and the decision is taken by means of a
majority vote. A vast literature already exists that seeks to explain the end
product of the committee's meeting - the policy outcome. Here, I take a
step back and explore the manner in which committee members think and
deliberate in order to arrive at their judgment.
In a must-read speech titled The Logic of Monetary Policy15, Ben
Bernanke draws the analogy of the economy as an automobile, the
Committee as the driver, and monetary policy actions as taps on the
accelerator or brake. When the economy is running too slowly - growth is
below potential - the Committee increases pressure on the accelerator by
lowering the policy rate, thereby stimulating economic activity. When the
economy is running too quickly, the Committee presses down on the
brake by raising the policy rate. In real life, in view of the severe
informational constraints that the Committee faces - data coverage,
frequent revisions, lags - the driver cannot determine the speed of the
automobile. The road ahead is also not visible - forecasts are vulnerable
to unanticipated shocks in the future. Hence, the monetary policy
committee is like driving a car with an unreliable speedometer, a foggy
windshield, and the car responds to the accelerator or the brake with some
delay (Bernanke, 2004). In sum, 'not a vehicle for inexperienced drivers'
is the way in which Bernanke describes the monetary policy committee.
Turning to the deliberations of monetary policy committees, I would
recommend a paper that models these discussions on the basis of
verbatim transcripts of the meetings released to the public. It is titled
"What's So Funny About Making Monetary Policy?"16 These transcripts
reveal that a member's statement is sometimes followed by "[Laughter]".
Is there any association between the number of laughs elicited by a
member during a meeting, on one hand, and the member's expectations
about the macroeconomy? If the elicitation of laughter has a small
probability - monetary policymakers say many things, but only few of them
are funny - then, by the "law of rare events," it will approximately follow a
Poisson distribution with an exponential conditional mean function. To
control for the possibility that some members may elicit more laughter than
others because of their sunny disposition, the model includes member-
specific fixed effects. Meeting-specific fixed effects are also included in
order to control for the possibility that more laughter is elicited because of
things like sunny weather. The only other explanatory variables used by
this study are macroeconomic forecasts made by members of the FOMC.
The results show that a member elicits more laughter during a meeting if
he or she expects relatively poor macroeconomic performance in the form
of higher inflation or lower employment or slower growth. This is a finding
of major significance. It transcends monetary policy and has profound
sociological and psychological implications.
Communication
Let me turn to another important aspect of monetary policy making that
has perhaps gained the maximum prominence in recent years. Central
banks communicate freely and frankly on their policies. They are mobbed
and often make headlines. Central bank communication has become an
independent subject in its own right to which papers, books and
conferences are devoted. Modern central bankers consider it vital to
communicate their decisions to the public in a lucid and unambiguous
manner. Their understanding of central bank transparency and
communication has changed dramatically. As it became increasingly clear
that managing expectations is a central part of monetary policy,
communication policy has risen in stature from a nuisance to a key
instrument in the central banker's toolkit17.
Right up to the early 1990s, however, this was not the case. Constructive
ambiguity is the description given to the manner in which central bankers
communicated. In fact, it is in that context the term Fedspeak was coined,
described as 'mumbling with great incoherence'18. It was believed that a
language of purposeful obfuscation is much better than saying "No
Comments" or "I can't or won't answer".
Today, central banks are acutely conscious that their actions taken at the
very short end of the market spectrum have to be amplified to move the
whole yield curve up or down. This is especially important when the policy
rate has hit the zero lower bound. Thus, communication has morphed
from a facilitator of monetary policy to a new policy instrument in its own
right19. As Ben Bernanke puts it: "monetary policy is 98 per cent talk and
only two percent action"20.
There is a growing body of work on the new approach of textual analysis
that is challenging economists and providing new insights into monetary
policy decision making. In the RBI, we are conducting studies on our
monetary policy communication by text processing the minutes of the
MPC at multiple levels using text mining techniques. The preliminary
findings are that the length of the minutes was higher during 2019 -
presumably reflecting deliberations on rate cuts -, in periods following
different waves of COVID-19 and after the start of the war in Ukraine. The
minutes are fairly readable and readability levels21 are consistently
maintained. In the period following the war in Ukraine, sentiment
deteriorated among both internal and external members.
Most recently, an aspect of communication that has caught the
imagination of the public is the 'policy pivot' - deliver a 75 basis points
rate hike and then, through subtle shifts in messaging, convince markets
that dovishness will characterise the next monetary policy meeting22. An
example is the post-council meeting conference of the ECB. In its
statement, there was a subtle change of tone. A similar pivot is evident in
19
Blinder, Alan S. Through a Crystal Ball Darkly: The Future of Monetary Policy
Communication, AEA Papers and Proceedings, 108:567-571, May 2018.
20
Bernanke, Ben S. 2015. "Inaugurating a New Blog." The Brookings Institution, March
30, 2015.
https://www.brookings.edu/blog/ben-bernanke/2015/03/30/inaugurating-anew-blog/
21
Readability is estimated based on word size and length of sentences. Smaller words
and shorter sentences tend to enhance the readability.
22
Martin, A., 'ECB Convinces Markets it is About to Turn More Dovish', Financial
Times, October 28, 2022
Chair Powell's press conference on November 2 after delivering a 75
basis points rate hike23.
Conclusion
Monetary policy has been termed as an art, a science and a craft. Yet, at
its core, it is all about informed human judgment constrained by high
uncertainty, which cannot be replaced by mechanistic models or rules.
Much of what goes into the monetary policy decision evolves from the
deliberations that monetary policy makers have with each other, with the
public and from feedback. All these processes inherently imbue the lighter
side of life. A psychological explanation of this phenomenon is that
monetary policy makers are trying hard to cope with the stress of a
perceived threat to the economy, as I mentioned earlier. This suggests
that they need to have a sense of humour in order to stay sane. An
"inflation nutter" who is strongly averse to inflation might go nuts if he or
she expected higher inflation but did not have a sense of humour. Also,
monetary policymakers may simply have better jokes about bad outcomes
than anyone else, especially inflationary outcomes. Again, humour may
be a coping mechanism. In closing, I will submit that humour in monetary
policy making reflects serious concerns about the economy, rather than
any lack of concern or sense of complacency that Paul Krugman
misreads.
Thank you.