More monetary policy guidance, please

Over the past several years, market expectations of the Reserve Bank policy rate have regularly diverged from the Bank’s policy guidance. Had market expectations been more aligned with the Bank’s, there would have been a lot less market volatility. The Reserve Bank can better anchor expectations to its policy path by reducing the uncertainty around how it would react to shocks and data outcomes.

In recent monetary policy committee (MPC) news conferences, committee members have frequently used the truism “decisions are data dependent”. This phrase has become increasingly commonly used by policymakers at major central banks. But their decisions do not just depend on how the economy is evolving. They must be part of a coherent monetary policy strategy.

Central bank best practice is to communicate the bank’s assessment of the drivers of the economic outlook and its monetary policy strategy, providing enough information for the market to evaluate the reasonableness of the MPC’s assessment and its policy decisions.

Around the world, analysts have been asking central bankers the same question: “When will you begin to cut interest rates?” Yet many central banks have been reluctant to answer this question. There are two reasons for this. The outlook for the economy is always uncertain, and therefore it is difficult to know when inflation will fall persistently. The other is that most central banks do not explicitly explain how careful they want to be in driving inflation lower. A central bank may, for example, prefer to adjust interest rates slowly only as inflation falls to avoid having to raise rates again, or it may wish to cut more quickly if it is worried about the impact high interest rates might be having on growth.

Best practice among inflationtargeting central banks is to be clear about the bank’s inflation target and how the bank is likely to react to specific shocks if they occur. Private sector analysts may expect the economy to evolve differently to projections provided by the central bank or may expect different policy decisions to what are observed.

If a central bank does not communicate policymakers’ policy preferences and the information underlying its forecasts, it is hard for market analysts to distinguish whether a central bank has a different tolerance for inflation than assumed by analysts or whether central bank forecasts might reflect confidential information policymakers are privy to.

Ambiguity about policy preferences or secrecy around projections shield central banks from scrutiny about the quality of their economic analysis and decision-making.

Central banks do differ in how much information they make public. International best practice is to publish forecasts and explain how policymakers expect to have to set policy to achieve their target. While the SA Reserve Bank publishes forecasts and a projection for the policy rate, it does not provide quarterly profiles for many key variables, including GDP and the policy rate.

The Bank also provides a short written MPC statement each time it makes a policy decision. By international standards, the Bank allows a lot of analyst interaction with the MPC, with question-and-answer sessions, monetary policy forum events, speeches by MPC members and analyst conference calls.

In line with other central banks, the Bank has increased its public disclosures over time. An analysis of its communication by Du Rand et al (2021) found that communication has improved over the past two decades. But the research notes that there has been an absolute decline in speeches over recent years and that more policy communication through MPC statements has not implied greater clarity of communication.

Another important aspect of best practice among major central banks that use models to communicate forecasts is to publish forecasts that are consistent with the currently decided policy stance, or at least to publish scenarios that explain any deviations in monetary policy decisions from their published forecasts. The Reserve Bank does not provide detailed analytical content explaining its balance of risk assessment or explicit scenario analysis, choosing instead to publish analytical content related to its forecasts in its bi-annual monetary policy statement.

The Bank stands out from best practice in publishing forecasts that are not necessarily consistent with its policy decisions. Central banks where the MPC does not “own” the published forecasts typically label such forecasts as “staff forecasts” to clarify that they may be based on different assumptions and judgments about the outlook for the economy than underlies the MPC decision.

While the Reserve Bank uses a model to produce its projections, it sometimes publishes forecasts that are not based on the actual decisions made by the MPC. This creates uncertainty around the Bank’s reaction function (that is, how the Bank will react to specific economic shocks) and makes it difficult for market participants to anticipate how interest rates might change over time.

Commentators and analysts also have a hard time interrogating the reasonableness of projections since it does not communicate the economic narrative underlying monetary policy decisions through the lens of its main forecasting model.

Another problem with providing limited analytical content alongside policy decisions, as the Bank does, is that there is pressure on the MPC to provide information about its views and preferences in forums outside its public disclosures.

This is also why Harvard economist Greg Mankiw has called for the US Federal Reserve’s news conference to be cancelled. He asserts that the Fed chair “seems to be conveying the least possible information in the most words possible”. He argues that policy statements should provide all the required information to understand policy decisions and the central bank’s assessment of the balance of risk around its projections and how it might respond to shocks.

Others argue that too much transparency could reduce central bank credibility if projections turn out to be incorrect. Like other central banks, the SA Reserve Bank’s post-pandemic projections for inflation proved inaccurate as it initially assumed that the pandemic and economic lockdowns would have predominantly demand-side effects. This meant the spike in global inflation caught the Bank by surprise, as it has been slow to revise its judgments about the underlying trends in the economy, for a long time holding on to a view that inflation pressures would be transitory despite growing evidence to the contrary.

The Reserve Bank, like other central banks, eventually attributed more of the second quarter 2020 fall in GDP to supply shocks. This gradual change in interpretation of economic developments amounted to an acknowledgment that the inflation impulse being observed was not just a temporary phenomenon and that risks to trend inflation were intensifying.

Central banks should not be vague when they are uncertain about the future. They should communicate what they are uncertain about and how they make decisions in the context of uncertainty. Transparency about the assumptions underlying projections help the market assess the reasonableness of these assumptions and the implications for central bank policy. Leading central banks even publish the code to their models so the public can learn how central banks might react if certain shocks occur and assess whether policymakers are learning from their mistakes.

Greater analytical detail and more clarity around the conditionalities associated with the Reserve Bank’s projections would reduce the risk of the Bank surprising the market. This would reduce market uncertainty and unnecessary volatility in interest rates and other asset prices. It is time for the Bank to provide more guidance about its monetary policy decisions.