Workshop in Norges Bank May 5 and 6 2003
by Peter Andrews, Bank of England[Title slide]
I am both honoured and a little embarrassed to have been invited to make this
comment. Honoured because I am filling Mervyn King's shoes for a day;
embarrassed because the paper is so kind about our Inflation Report that to criticise it
seems churlish and to praise it seems immodest.
[Benchmarking and measuring performance]
First, thanks to our hosts for commissioning this paper. Central banks are, by
definition, unique in their own country. And although it should be easy to measure
whether or not they are hitting a quantifiable objective, such as an inflation target, it is
much more difficult to quantify how they are performing with respect to their other
objectives. Yet both our stakeholders - the government and the public, to whom we
are accountable for the value for money we provide and the competence with which
we do our job - and we ourselves, looking to improve what we do, can benefit from
measuring how we are doing and comparing ourselves with best practice elsewhere,
which often can only mean in other central banks. For these reasons the Bank
welcomed both Don Kohn's report, in 2000, on the procedures for providing briefing
and analysis for MPC, and Adrian Pagan's 2003 report on where our macroeconomic
models stand in relation to international best practice, and published these reports.
Inflation reporting, or publication strategy more generally, is another important area,
so we welcome a paper which sets quantifiable benchmarks from international
experience.
To illustrate the difficulty of quantifying success in this field, this slide shows you one
of the Bank's ten strategic objectives for 2002-03, published in our last Annual
Report: the IR, and the rest of the publications programme, is intended to build public
support. The Monetary Analysis area, which produces the report with MPC sign-off,
is setting itself for 2003-04 a performance indicator which relies on outside feedback.
But we have not previously had quantitative information of the kind in this paper to
draw on, certainly not on any kind of comparative basis. (I understand we will in fact
draw on this paper for the 2003 Annual Report! and I expect others here will wish to
do the same).
[Objectives slide]
Nevertheless, I'd like to suggest several ways in which this sort of work needs to be
taken further. I'll look further at the macroeconomic objectives we can expect an
Inflation Report to fulfil, and indeed our publications strategy more generally, and
will then look at some alternative measures of success, at least in the UK.
Our Inflation Reports start by setting out two purposes. The first one listed is the
contribution that preparing it makes to the quality of the policy process itself. The
economic framework associated with the forecast process obliges MPC members to
identify and discuss the key current issues as they reach their decisions. The
explanatory objective is listed second. And I mention for completeness that
publication of the IR is now a legal requirement, so that its part of the machinery by
which the Bank is accountable for the way it carries out its remit.
That suggests that one criterion for the success of Inflation Reports is the success of
policy itself - inflation close to target, and subject to that strong and sustainable
growth. But the spirit of this discussion is to look at the explanatory purpose:
- how clearly understood is the Bank's policy?
- how credible is that policy, i.e. do financial market participants believe that we
will carry it out.
[November 2001 Spot Curve - Front 5 Years, Before and After]
The paper takes as a key criterion the extent to which monetary policy decisions are a
surprise, measured by the same-day change in 3 month rates. That is a good measure
of how much a decision has surprised market participants. But I question how much
macroeconomic significance it has. It is rightly argued that rates longer than the
policy rate are important for pricing assets. But the three-month horizon is too short
to give much information on that front. So let's look at some recent examples of
surprising monetary policy decisions. First a small surprise. This is the front end of
the government yield curve on the day of the 50 basis point repo rate cut in November
2001. The three-month LIBOR rate, the measure used in the Genberg study, fell by
17bp that day, suggesting that the market had thought the 50bp cut we actually made
was possible but less likely than a 25bp cut. The government curve only showed a
material fall out to a year or so. Although the extent of the cut had some surprise
value, it did not materially change their view of the future path of interest rates. And
that was despite the fact that the ECB cut rates on the same day, and the Fed had cut
the previous night - all of which should be picked in the same day's change in rates.
[Inflation expectations before and after]
In the UK, we can also measure the effect of monetary policy announcements on the
inflation expectations implied by the differential between the yields on index-linked
and conventional gilts. I would warn against over-precise interpretation of these
implied inflation rates - the indexed market is a bit less liquid than the conventional.
On the day of that 2001 decision, qualitatively there was just a slight rise in inflation
expectations as a result of this surprise rate cut decision. Overall, then, although the
Bank's published information - the August IR, minutes of meeting in September and
October, etc - did not allow complete anticipation of the decision, the market's
expectation of the key market variables, and the basic credibility of the strategy, were
not much affected.
[February 2003: Before and After]
By way of contrast, here is what happened when UK interest rates last changed in
February 2003. Measured by the change in 3-month LIBOR, the "surprise" on the
day was 20 basis points or so, a bit larger than the November 2001 surprise, but in the
same ballpark. But if we look at the front of the spot curve, we see the fall in market
rates was much the same at a year as at three months, and the surprise extended along
the curve.
[Implied inflation rates: February 2003]
And perhaps as you'd expect, the reaction of implied forward inflation expectations
was much more marked than in the previous case: up to 13 basis points 5 years out,
taking inflation expectations closer to target, though still slightly below it at all
horizons. So although the "surprise" element of the decision by the Genberg criterion
was not much larger than in November 2001, the effect in terms of the things we care
about and write about in the IR was a lot larger. Reactions in the equity market and in
sterling were greater, too.
[March 2003 minutes: before and after]
While we look at these market data I should make one further point. Inflation
Reports, and other publications such as the MPC minutes, may reduce the surprise
entailed by monetary policy decisions. But the corollary is that the publication of that
information can itself be an event with the capacity to move markets. Here, for
example, is what happened when the minutes of the March 2003 MPC meeting were
published. Nominal spot yields rose along the curve by up to 20 basis points.
[March MPC minutes inflation expectations]
And inflation expectations rose at the short end and fell further out. Anecdote
suggested that the market was influenced by a discussion in the minutes on the pros
and cons of a rate rise, even though no member voted for a rise. So here is a case
where what the central bank said looks to have had as much or more impact as its
actions.
[Summary on Interest Rate Surprises]
So to summarise: short rates may not be the clearest way of establishing how
surprised the market was by a monetary policy decision; and longer-term interest rates
and inflation expectations are also of greater macroeconomic significance.
[Direct Measures of Public Opinion]
I'll raise some other points for discussion on the empirical study in a moment. But I
suggest a completely different measure of the effectiveness of central bank
publications strategy: opinion polling.
For over three years, the Bank has had an opinion poll conducted each quarter. We
publish the results on our website. We look at the inflation expectations of the
general public, but also at their general understanding of monetary policy, which is
arguably an important test of our information strategy.
[Knowledge of Transmission Mechanism]
For example, we test understanding of the proposition that higher interest rates bring
about lower inflation. We get a positive balance of responses to that, although there is
a significant proportion of don't knows. Given that interest rates tend to be high when
inflation is high, so that a member of the public observing the casual correlation
would come to the wrong conclusion, the result is quite encouraging about basic
understanding of how monetary policy works.
[Satisfaction with BoE]
It is helpful for the monetary authority to enjoy public acceptance that it is doing at
least a reasonable job. That helps to reinforce confidence in the inflation targeting
framework, and probably also confidence that inflation will be maintained close to
target, which in turn must be helpful for example in keeping pay expectations and
pricing behaviour in line. This slide shows that the Bank has enjoyed a generally high
level of support over the last four years; the balance of those satisfied against those
dissatisfied has always been positive. Support picked up when the Bank was very
visibly cutting rates in the autumn of 2001, but the balance was still solidly positive
when interest rates were at their high point for the last cycle. As a matter of fact, the
Governor typically receives more letters of complaint when interest rates are low,
perhaps because the elderly savers have more time to write letters than those with
mortgages.
[Who makes monetary policy?]
As a light-hearted warning against complacency - and as a way of helping you
calibrate the reliability of the previous information - this slide shows that typically at
least half the population, asked the question "each month, a group of people meets to
set Britain's basic interest rate level. Do you know what this group is?" answer that
they don't know. Most people who pick one of the options do at least pick the Bank,
or the MPC.
[Summary on opinion polling]
So to summarise, direct polls perhaps get us closer to measuring what we would like
to influence through our communications strategy: public understanding of what
monetary policy is trying to achieve. But we have to be realistic about the meaning of
the results, given the large proportion of the public whose understanding is hazy. It
would be interesting to compare notes with any other central banks who undertake
comparable studies.
[Range of publications]
An inevitable limitation of today's paper is that each central bank has a different
range of publications, each of which may take on some of the functions suggested for
an Inflation Report in today's paper.
By way of example, here's a list of the Bank of England's publication programme on
monetary policy issues. The Inflation Report presents a description of current
economic conditions, and the outlook, including the range of uncertainty; it briefly
summarises the minutes of three previous meetings; and it periodically summarises
the forecast record. But it does not debate monetary strategy issues (research on
monetary strategy appears in the WPs and QB, and debates in MPC meetings about
how strategic principles should be applied of course appear in the minutes).
Objections to Committee decisions might well be dealt with in speeches or in the
Inflation Report press conference, which is an important event in its own right;
Mervyn King and colleagues taking questions for up to an hour. Assuming that other
central banks are similar in their diversity, it means, as the authors recognise, that a
study which judges only Inflation Reports by criteria which are appropriate for the
overall publications strategy, may produce misleading results.
[Points for Discussion]
One of the many benefits from this paper is that it will help to spark discussion on
what Inflation Reports should cover. Here's a contribution on some other issues
arising from the paper.
- It's important that we recognise the limitations of the projections described in IRs.
We stress that our projections are probabilistic. We don't publish point forecasts
and prefer to spend time on the balance of risks around the projections. That may
make it harder for a reader to follow the Report.
- I should stress that the Bank of England's inflation target is continuous through
time. We don't wish to become over-focused on the forecast at the two-year
horizon; two years is simply a useful horizon, because we believe that most of the
effect of an interest rate change today will have come through to inflation by then.
But different shocks hitting the economy today will have their impact over a
shorter or longer period than that - so policy may have to trade off deviations
from target at shorter and longer horizons.
- More generally, the Committee has to exercise degrees of judgement both in
constructing the projections and in setting interest rates having made its
projections. Neither is a mechanical exercise. The IR should describe the broad
forecasting judgements, while the second set of judgements, on the rate decisions,
is more appropriate for the minutes, month by month, though the first section of
the IR summarises the reasons for the decision that accompanies it. Again, all of
this can make the IR less than simple and clear, especially since committee
members may differ among themselves on these judgements.
- In order to keep the length of the IR within bounds, there is some information
which we don't repeat each time, so that your readers, looking at only one issue,
may have felt our coverage incomplete. For example, we look at the forecast
record once a year. And the November 1999 IR gave some detail on the
convention for projecting the exchange rate, which changed at that time, but we
haven't repeated that discussion each time.
- And in the "surprises" exercise, I noted that the range of macro economic control
variables is quite limited - just inflation. Given that several inflation-targeting
central banks take account of the variability of activity as well, it might have been
useful to include such a measure in the exercise.
[Summary]
So my main conclusions would be: this is a very welcome and innovative paper. The
exercise could be extended by looking at other measures of expectations - though I
recognise not every country has indexed bonds, or opinion polls of the kind the Bank
of England pays for. I noted the qualification that Inflation Reports are only part of a
central bank's communication on monetary policy, so their contents may not be
completely comparable. And there are points at which the message cannot be too
clear and simple, lest it be misunderstood: the judgements involved in making
economic forecasts and monetary policy are sometimes difficult.