Mark Carney on No-Deal Brexit: This is Modern Central Banking, but Please Handle with Care

 

Donato Masciandaro (Department of Economics, Bocconi University and SUERF)

On Friday the Governor of the Bank of England (BoE) Mark Carney said that there was as “uncomfortably high” risk of the UK leaving the European Union without a deal, and his comments sent the pound down. The episode tell us two tales.

On the one side, the negotiation of the channel between announcements, expectations and market sentiments is a normal and legitimate part of modern central banking strategy. On the other side, as it has been correctly pointed out (Alan Blinder 2018, Through a Crystal Ball Darkly: The Future of Central Bank Communication), many monetary policy models presume that central bank communication is aimed at households, firms and markets, but the crucial question is: who receives the central bank messages, and how? Given that such a question is still without clear and definitive answers, central bank communication tools have to be handled with a lot of care.

Thirty years ago, In the Concluding Remarks that Paolo Baffi – Governor of Bank of Italy – read on 31 May 1979, he zeroed in on the fact that “the actions of central banks are no longer cloaked in silence, and perhaps never will be again. Whereas in the past silence was seen as a guarantee of independence, today this is achieved by giving an explicit account of one’s actions”. The Italian Governor’s words recognized the increasing importance of the links between monetary policy and central bank communication in influencing the overall effectiveness of economic policy action in modern economies.

During the 1970s and 1980s, central banks were very much shrouded in monetary mystique and secrecy (Goodfriend, Monetary Mystique: Secrecy and Central Banking 1986). The theoretical rationale for the lack of monetary policy transparency and communication was given by the theory of ambiguity, credibility and inflation under discretion and asymmetric information developed in the seminal article of Cukierman and Meltzer (A Theory of Ambiguity, Credibility and Inflation under Discretion and Asymmetric Information, 1986).

The bottom line was simple: with asymmetric information between the public and the policymaker, monetary policy ambiguity is likely to produce inflationary surprises and consequently short run macroeconomic gains. The mix of a discretionary monetary policy with a short sighted policymaker can justify ambiguity; the negative spillover, with rational expectations, is likely to be higher and more variable inflation. It is worth noting that in such an approach the effectiveness of monetary policy began to be linked with the role of market expectations.

In fact the development of the modern theory of monetary policy, based on the intertwined concepts of rules in policy making on the one side, and independence and accountability of the policymaker on the other, naturally produced a change in the communication prescriptions, moving from secrecy toward transparency (Eijffinger and Masciandaro, eds, Modern Monetary Policy and Central Bank Governance, 2014). Monetary policy discretion and ambiguity was abandoned in favour of monetary policy rules explicitly announced and motivated. Transparency became a key feature of central banking policy.

The increasing role of transparency depended on the evolution of the monetary policy rationale. It has been progressively stressed that the effectiveness of central banks to affect the economy critically depends upon their ability to influence market expectations regarding the future path of interest rates, and not merely their current level. Therefore, the public understanding of current and future policy becomes critical for the effectiveness of policy. In other words, monetary policy increasingly became the art of managing expectations.

It is worth noting that Mark Carney’s remarks on a no-deal Brexit were exactly a case of expectations management. The Governor presented the results of a central bank’s standard stress test model, in which the BoE had modelled the no-deal Brexit scenario, where the final outcomes would be an increase in unemployment (9 percent), a decrease in output growth (4 percent) and an increase in interest rates (4 percent). Now the markets know the results of the central bank simulation, with all the caveats that such simulations imply.

Central banks have to disseminate the knowledge that they have – as the results of hopefully robust stress tests – through their communication policies. More effectiveness in the communication policy should lead to greater predictability of central bank actions, which, in turn, reduces the uncertainty in financial markets. The ability of the central bankers to influence macroeconomic outcomes and the predictability of policy decisions are not independent of each other, as communication that leads to high predictability of decisions may also have a significant effect on the economic system as a whole.

Therefore the more it is true that, given the expectations, the market reaction isn’t mechanically guaranteed, the more it will be true that communication matters as a device to increase the likelihood that expectations, announcements and sentiments are consistently settled.

In other words, – still paraphrasing Blinder – who correctly receives the BoE message, and how? Unfortunately, it is by no means clear so far what constitutes an optimal communication strategy. Any communication strategy of a central bank can produce intended and unintended effects, i.e. the consequences of the three channels already described – expectations, credibility and macroeconomic variables – can be positive or negative. Therefore an approach of “more information is always better” is neither sufficient nor correct.

Therefore the policy of communication adopted by each central bank has to be carefully studied, by highlighting at least three different aspects: contents, procedures and timing.

First of all, the contents of communication must be distinguished, which can be either quantitative or qualitative; another distinction is between backward-looking and forward-looking statements; further the topic of the communication – i.e. macroeconomic performances, including inflation – can be relevant.

Secondly, the procedures of communication must be considered. These can take the form of either a press release, or some other form of statement, from various possible communication senders (committees or individuals). On top of that the role of language is crucial. In measuring the content and the tone of the central bank communication, two approaches have been used in the literature: human coding and automated coding. In this strand of literature computational linguistic tools have been used to analyze monetary policy communication. Recently the use of the social media – namely Twitter – has been explored as an information device for central bankers.

Thirdly, the timing of communication must be investigated, at least from two points of view: in absolute terms, by distinguishing periodical, institutional communication, which is predictable, from those announcements that are not; in relative terms, with respect to the functioning of financial markets or to the habits of the investors. Among the institutional communication, the literature has emphasized the role of minutes and their timeliness.

In this respect, the Mark Carney interview during the BBC’s Today programme can be considered as another case study in order to analyze how and who received the BoE messages. Nothing more, nothing less. Central bank communication is crucial, normal and legitimate, but it has to be handled – and also commented on – with care.