What and how should central banks talk?

Monday, 13 January 2014 00:00 -     - {{hitsCtrl.values.hits}}

Impact is the criterion to evaluate a public policy action Public authorities normally tend to communicate their accomplishments by reporting to the public the number of actions, known as outputs produced, they have taken during a given period. For instance, a municipality may report the number of trees it may have planted along a street without bothering to count the number that is still growing after one year. Economists do not consider this as a suitable criterion to assess the performance of any public policy action. For them, the performance of a public policy action cannot be assessed even by looking at the changes, known as outcomes, which such actions have generated. According to them, a public policy action can be assessed only by considering the results or the impact which that policy has created in society. If the action has not created the expected impact or if the impact has worked in the opposite direction or it has resulted in unintended consequences, then, the public sector entity or its policy action is viewed as a failure. Norochcholai has produced a marvellous output but poor impact The best example is the Norochcholai Coal Power Plant where the Ceylon Electricity Board or CEB has delivered the output fully (building of the power plant and commissioning it) and outcome partially (making a little change in the structure of power generation method). But its impact has not been up to the expectation since it had been out of commission for most of the time inflicting enormous unplanned costs on CEB (one expected result was to reduce the cost of power generation by using cheaper coal) and upsetting CEB’s planned purchase of power from private power generators. In fact, the frequent break-down of the power plant has created doubts in the minds of the public about the efficacy of the coal-power generation technology used in the plant. Central Bank Road Map ’14 has praised outputs but been silent on impacts The Central Bank in its Road Map 2014 that has outlined the monetary and financial sector policies for 2014 and beyond has recognised the output part of the Norochcholai Power Plant and other such plants to be commissioned in the future (Slide 90 of the presentation available at www.cbsl.gov.lk). It has conveniently ignored the impact part of the power plant assuming that if a power plant is commissioned it will make the expected contribution to the economy no matter how that power plant is built or operated. With respect to the other infrastructure projects too that have come up in the recent past, the bank has followed a similar evaluation criterion. It has communicated to the public the output part keeping a stoic silence about the impact part. Perhaps the bank would have assumed as it has done in the other cases too that if an output is created, its expected impact should naturally follow it. But the impact does not come automatically and if any value has to be assigned to any public policy action, that assignment has to be based on taking the entire process into account – from input or throughput to output, from output to outcome and from outcome to impact – and not just the initial output part. This throws light as to what and how a central bank should talk to people. "Central banks should be clear about what they plan to do – their goals, objectives and policy actions – in the immediate future as well as in the long run. This is not an easy task since many of these goals conflict with each other and if the bank is to attain one goal, it may necessarily have to sacrifice another goal. Hence, the choice of goals should be made by a central bank in such a way to avoid the potential conflicts among them. However, a central bank may sometimes not be in a position to give up some of the irrelevant and conflicting goals altogether because they may have been assigned to a bank by law or by tradition. In such cases, it is necessary for a central bank to make itself absolutely clear of how it will mitigate or avoid the potential conflicts in advance" Road Map ’14 has outlined a comprehensive communication strategy In the same Road Map, the bank has outlined its communication policy (slide 122) in order to manage the public’s expectations properly and thereby enhance the credibility of the bank’s policy measures. The bank has highlighted that “With advanced technology and improved information flows, and considering the importance of market expectations for the success of macroeconomic policies, the Central Bank will continue to provide information to all stakeholders in an effective manner”. The effective communication methods to be employed by the bank have been the issue of press releases and statistical updates, publication of statutory reports, presentations made by the bank’s senior management, maintenance of a continuous dialogue with domestic financial sector and international investors, educating media personnel and financial sector employees, and the use of social media to communicate with the public including twitter through which the public can tweet with the Governor. This is a comprehensive communication policy provided what is communicated is not just outputs but impacts if the Central Bank is interested in enhancing its credibility. Some believe central banks should be secretive There are some who believe that central banks should keep their actions in secrecy and should not divulge them to the market. There is a valid foundation for this belief. If central banks do not talk to the people about what they are planning to do, the people on their part will have to keep on guessing all the time. As a result, whatever the action taken by a central bank, the markets and those who participate in the markets are taken by surprise with no power to predict accurately what will happen in the future. Thus, having been handicapped by lack of correct information, people are unable to take measures counter to the central banks’ policy actions. As a result, they believe that central bank actions are more effective when they shock-deliver their policy actions to the people. Empirical studies have justified central bank openness However, recent research conducted on central banking has revealed that the central bank communication is as important as the central banks’ policy actions. A Working Paper prepared by Michael Ehrmann and Marcel Fratzscher for the European Central Bank of ECB in 2005 under the title ‘How should central banks communicate?’ has concluded, based on the communications made by the Federal Reserve System, Bank of England and ECB, that ‘central bank communication is a key determinant of the market’s ability to anticipate monetary policy decisions and the future path of interest rates’. However, the research has found that it is more effective when the top central bankers talk in one voice instead of coming up with diverse individualistic ideas. In a subsequent Working Paper prepared for ECB in 2011 by the above two authors with Benjamin Born on ‘Central Bank communication and financial stability’, it has been found that Financial Stability Reports published by central banks have a significant and potentially long-lasting effect on the stock market returns and also contribute to reduce the sudden adverse changes in the market known as ‘market volatility’. However, they also have found that the speeches delivered and interviews given by top central bankers during normal times have a very little impact on the markets, though in crisis situations they help central banks to build confidence among the public. Thus, central bank communications are important to attain the best results for their monetary policy as well as financial system stability policy actions. Three pillars of central bank communication The experts on central banking have elaborated on three basic features which central bank communications should contain in order to be acceptable to markets. They are the clarity, transparency and predictability of communications. Clarity of central bank communication a must Central banks should be clear about what they plan to do – their goals, objectives and policy actions – in the immediate future as well as in the long run. This is not an easy task since many of these goals conflict with each other and if the bank is to attain one goal, it may necessarily have to sacrifice another goal. Hence, the choice of goals should be made by a central bank in such a way to avoid the potential conflicts among them. However, a central bank may sometimes not be in a position to give up some of the irrelevant and conflicting goals altogether because they may have been assigned to a bank by law or by tradition. In such cases, it is necessary for a central bank to make itself absolutely clear of how it will mitigate or avoid the potential conflicts in advance. Assigning both public debt and EPF to Central Bank has generated a conflict in Sri Lanka A case in point is the conflict faced by Sri Lanka’s Central Bank in its dual role as manager of public debt and as manager of the Employees Provident Fund or EPF. In the case of the former, the bank has to find money for the government at the cheapest rate; in the case of the latter, it has to invest monies of the Fund to get the highest rate of return. These are two goals that cannot be attained simultaneously by the bank when it invests EPF monies in government Treasury bills or bonds. It thus requires Sri Lanka’s Central Bank to decide on a suitable course of mitigation in advance. Once such mitigations are decided by the bank, they have to be communicated to the public clearly to avoid doubts and confusions. Central banks should be open and transparent Transparency of central bank action relates to the openness in explaining the rationale of its policy action to the public. The former Vice Chair of the Federal Reserve Board, Roger W Ferguson, Jr, in a speech delivered at the Graduate Institute of International Studies, Geneva, in 2002 has elaborated on this point as follows: “The rationale for policy actions cannot be fully understood unless the central bank is reasonably clear about its long-run objectives. That is, the monetary authority should be forthcoming about its strategic goals as well as about the short-term tactics that it uses to achieve them. Finally, the central bank needs to describe the economic environment in which it expects its actions to be felt” (available at: http://www.federalreserve.gov/boarddocs/speeches/2002/20020108/). In this sense, the Road map series of Sri Lanka’s Central Bank is a commendable attempt at explaining the rationale of its policy action to the public in the current economic policy environment. In normal situations, central banks should speak the whole truth However, transparency is a double-edged sword. In a normal situation, a central bank can practice transparency to its full meaning maintaining openness in every action it takes. Openness requires a central bank to be truthful in its policy actions – not just half-truths but whole truths in its public communications. Markets love such openness since they could predict central bank’s action with a fair degree of accuracy. Such understanding on the part of the market will lead to orderly behaviour in the markets which is a must for a central bank to attain the full results of its policy actions. This has been confirmed by Benjamin Born, Michael Ehrmann and Marcel Tratzscher in a paper published in The Handbook of Central Banking, Financial Regulation and Supervision edited by Sylvester Eijffinger and Donato Masciandaro and published in 2011. Full transparency may worsen crisis situations But at a time of crisis, a central bank does not enjoy the luxury of being fully transparent, open and truthful. This is because truth becomes bitter if people are driven by panic and not ready to accept it as rational individuals. In a crisis, like in a war, everybody is driven by desire to save himself and guided by this self-protecting interest will create a chaotic situation in the market. The central banks’ role in this situation is like the role of a wise physician who has just diagnosed a terminal illness in a patient. If in the assessment of the physician the patient is not ready to accept the truth, the physician will think twice before he breaks the deadly news to him. Similarly, a central bank can become the trigger point of a financial and economic crisis if it, in the name of truthfulness, openness and transparency, divulges the true facts to an already panic-driven market. In such a situation, a central bank could bring order to the market it does not follow these principles to the letter. What this means is that a central bank is not guilty of not telling the truth or telling a half-truth at a time of a severe crisis. Depositors of failed financial institutions accuse the Central Bank of Sri Lanka of not alerting them sufficiently in advance about the impending disasters. But, they should realise that had the Central Bank given advance warning of an impending failure of a financial institution, it would have speeded up its failure causing all depositors to demand their deposits at the same time and thereby driving the entire financial system to a crisis situation. The central banks’ role in such a situation is to save as much as possible and its communication strategies should be guided by this consideration. Central banks should report Balance of Risks or BOR However, this does not mean that a central bank should keep the public in the dark in normal times. Its communications, while presenting the rationale of its actions, should necessarily contain a statement of risk assessment and how the central bank will balance the risks. This statement, known as the Balance of Risks or BOR, is not unknown to financial regulators. They have in fact imposed this as a mandatory requirement when a financial institution seeks to go to the market to raise funds as equity or as debt. This is to keep the public aware of the risks and costs they have to face and bear when they invest in such financial institutions and avoid the gullible public being misled by crafty marketing techniques used by them. What central banks have prescribed to institutions regulated by them should be good enough for them also to follow as a good practice. What this means is that central bank communications should not be mere propaganda stints highlighting only the good sides. They should also contain a BOR so that the public will form opinions on the state of the economy and the financial system with full knowledge rather than with half knowledge or no-knowledge at all. Central banks should learn from outside criticisms A good quality which a central bank should cultivate in itself to play this role properly is to be receptive to outside criticisms. Such criticisms not only help a central bank to identify its own weaknesses but also to steer its future policy actions. Those in central banks may be overjoyed when they kill outside criticisms by making blunt attacks on the critics. But Adam Smith’s ‘Impartial Spectator’, presented by him in his 1756 publication The Theory of Moral Sentiments, who represents the collective conscience of the public will continue to haunt them throughout if they have done something improper. The central bank communications, while explaining a bank’s rational action, should therefore be free from such personal attacks on its critics. (W.A. Wijewardena, a former Deputy Governor of the Central Bank, can be reached at [email protected].)

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