| Dilemmas in central bank communication |
| Some reflections based on recent experience |
| Duvvuri Subbarao / New Delhi January 10, 2011, 0:18 IST |
1. First of all my thanks to Business Standard, and to my good friends T N Ninan and Sanjaya Baru, for inviting me to deliver this second Business Standard Annual lecture. This is an honour to which I attach a lot of value.
Central Bank Communication
2. As a part of my job, I accept several speaking commitments, and often I struggle to determine the topic for my speech and the key message I should be delivering. From that perspective, deciding on a topic for this lecture has been relatively easy. I have chosen to speak on ‘Dilemmas in Central Bank Communication’, and that choice has been motivated by three reasons.
3. First, over two years into the job as Governor of the Reserve Bank, I am still traversing a steep learning curve. I have learnt many things, and one of them is that communication of policy is as important as the content of policy, and is oftentimes more challenging.
4. The second motivation for my choice of the lecture topic comes from the experience of the recent crisis when central bankers around the world realized how communication is critical to the effectiveness of crisis management policy. This bias towards openness actually reflects a remarkable shift in stance on the part of central bankers. As Liaquat Ahamad says in his best selling book, ‘Lords of Finance’, central bankers had previously believed that in times of crisis, it is prudent to obey the admonition of mothers, across cultures, to their children: “If you can’t say anything nice, don’t say anything at all.” This follows from the recurring dilemma that central bankers face in times of panic. If you make an honest public statement, you end up feeding the frenzy. On the other hand, if you try to be reassuring, you have to twist the truth. In recent decades, however, central bankers have been increasingly persuaded that even in times of stress, they are better off communicating rather than not communicating. The recent crisis reinforced this growing faith in communication as central bankers realized, much to their relief, that keeping the public informed and updated actually reduced rather than exacerbated anxiety and panic.
5. The final reason for my choosing this topic is quite straight forward. This lecture is sponsored by a media house, and what better platform than this to share with the public some of the dilemmas and challenges we face in our communication strategy.
Domain of Communication
6. Central bank communication has been the subject matter of much intellectual discourse, but this has almost always been in the context of communication of monetary policy. That is understandable because monetary policy is at the heart of central banking and also possibly because communication of monetary policy is arguably more challenging than communicating other policies. In my lecture today though, I will speak about communication in a broader context - not just with reference to monetary policy but also encompassing other dimensions of the Reserve Bank’s mandate such as, for example, regulation and supervision, currency management and external sector management.
Alan Greenspan - the Doyen of Communication!
7. It would be blasphemous to speak about central bank communication without first paying homage to that doyen of central bankers - Alan Greenspan. So let me get on with it.
8. Greenspan is notoriously famous for several things including for transforming central bank communication to an art form. “Since I’ve become a central banker”, he said in 1987, “I’ve learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.”
9. After nearly 15 years on the job, in October 2001, Greenspan took a U turn saying that, “Openness is more than just useful in shaping better economic performance. Openness is an obligation of a central bank in a free and democratic society. Transparency of our activities is the means by which we make ourselves accountable to our fellow citizens to aid them in judging whether we are worthy of that task”. Indeed, we owe it to Greenspan, and perhaps his Delphic utterances, for generating much learned commentary on why central bank communication is important.
Why is Central Bank Communication Important?
10. Over the last two decades, central banks have moved towards clearer communication and greater transparency. This has been driven by several motivations.
11. First and foremost, central banks have realized that open and transparent communication enhances policy effectiveness by way of achieving expected outcomes. This shift in central bank theology from deliberate obscurity to greater transparency actually reflects a shift in the theory of monetary policy. Up until the early 1990s, monetary policy was strongly influenced by Nobel Laureate Robert Lucas’ argument that monetary policy affected real variables, like growth, only if the policy changes were unanticipated. This encouraged obscurity over openness and clarity. However, lost in the message was that monetary policy always affected nominal variables like inflation even if fully anticipated. In the 1980s, two economists, also Nobel winners, Finn Kydland and Ed Prescott, argued that fully transparent rules rather than discretionary policy changes were more efficient and credible. This was the beginning of the push towards rules over discretion and greater central bank transparency.
12. The most eloquent illustration of this shift towards transparency is the change in the communication strategy of the US Fed. Hard as it might be to imagine from today’s perspective, prior to 1994, the US Fed was not even announcing the target Fed Funds Rate; the market was expected to infer the rate from the timing, sequencing and magnitude of its open market operations. In sharp contrast, today the Fed not only announces the rate but also gives a clear indication of future policy trajectory. Indeed, it is standard practice for central banks these days to indicate the policy rates, the rationale behind the policy action, the expected outcomes, and oftentimes to give forward guidance on future policy actions.
13. While communicating policy after it is made is the standard mode of communication, central banks are also increasingly taking to communication before policy action. This again is a lesson of experience - that the market does not like unexpected news, and that surprises should be avoided unless surprise is, in rare circumstances, part of the strategy itself. When the Fed announced last August that it would reinvest the proceeds of maturing securities purchased under the first phase of quantitative easing (QE1), markets were unnerved. In contrast, the elaborate communication exercise that preceded the recent QE2 brought much clarity to the Fed action and delivered the expected ‘announcement effect’. QE2 has of course come in for extensive criticism, but that is certainly not owing to any shortfall in communication.
14. We have had a similar experience at the Reserve Bank. Both on the way up to the crisis and on the way down, we had to make several ‘off-cycle’ policy adjustments. There was wide agreement that these measures were expedient; nevertheless they did not go down well with the market because of the surprise element. This has prompted us to revise our communication strategy by introducing, with effect from September 2010, more structured scheduled mid-quarter reviews. While we have not surrendered our flexibility to take policy action as and when warranted, more frequent scheduling of policy reviews reduces the need for off-cycle action and thereby minimizes the surprise element.
15. Sometimes, communication, instead of being a vehicle for policy, can be the policy itself. Drawing yet again from the US experience during the crisis, the Fed realized that its repeated announcement of keeping rates low ‘for an extended period’ led markets to reach a certain inference on what ‘extended period’ could mean. In this context, some policy analysts argued that a step that the Fed could consider was to modify the language of the statement to communicate to investors that it anticipates keeping the target Federal Funds rate low for a longer period than was currently priced in the markets. This, it was believed, would have eased financial conditions as was desired.
16. Communication can be a potentially powerful tool for getting feedback when the implications and the impact of proposed policy are uncertain. For example, the Reserve Bank has thrown open the issue of whether we should deregulate the interest rate on savings accounts, which incidentally is one of the very few interest rates that remains administered. There are persuasive arguments both for and against deregulating this. In the Reserve Bank, we realized that this is, like all big decisions, a judgement call and that we needed the ‘wisdom of the crowds’ in reaching a judgement. Discerning people would no doubt have realized that eliciting views and feedback is now standard practice for most policy decisions of the Reserve Bank.
17. Yet another factor that has motivated central banks into placing larger emphasis on communication is their hard earned autonomy in the years before the crisis. Central banks have increasingly embraced more open communication to counter the criticism that an autonomous central bank comprising unelected decision makers was inconsistent with a democratic structure.
18. Finally, central bank communication is important for the institution to learn, listen and understand. This is a lesson that we have taken to heart in the Reserve Bank. I am referring here not to the standard one way oral or written communication but to two way communication between the central bank and its stakeholders, with the central bank remaining largely in a listening mode. During our platinum jubilee last year, we launched the ‘outreach’ programme whereby all of us in the senior management together with our field office staff and accompanied by senior functionaries of commercial banks visited remote villages across the country. This was an immensely rewarding learning experience in several ways. Most, of all, we found that listening to people and understanding their concerns enriches our policy making in a very powerful way. Because of its enormous value add, we are continuing the outreach programme as a regular activity.
Communication - Illustration of Dilemmas
19. I have so far told you, with the help of some recent examples, why central bank communication is growing in importance. I have debated about how to go on from here. One option is to list all that we have done in the Reserve Bank to improve communication, but that may be a boring litany. Another is to give a 7 scholarly discourse on central bank communication but there are people around with greater expertise than I to do that. I have therefore decided that I will give you ten illustrations of the communication dilemmas and challenges that we have faced in the Reserve Bank in the recent period.
(i) Monetary Policy - to pause or not to pause
20. As all of you know, in calibrating the exit from the expansionary monetary stance of the crisis period, the Reserve Bank has been struggling with the growth-inflation dynamics over the last one year. By the time of the second quarter review in early November 2010, we had already raised policy interest rates five times. The central issue before this policy review was whether we should continue on the tightening spree or pause before resuming tightening later on. We consulted experts and economists and found that opinion was divided among them. One view was that we must pause for a bit in order for the rate hikes already affected to play out, and then resume tightening. The opposing view was that we should continue tightening to a point that would deliver RBI’s inflation projection and pause only after that. Inside the Reserve Bank, the view was that within the policy trajectory, it did not matter if we paused briefly as long as we remained committed to the eventual outcome. The dilemma then boiled down to communicating to the market that our action should be interpreted only as a comma and not a full stop. Whether or not we managed the dilemma effectively is, of course, for you to judge.
(ii) Monetary Policy Stance - Forward Guidance 21. Central banks have learnt that giving forward guidance on the policy trajectory is an effective way of managing market expectations. But they have also learnt that this is not a totally benign option. The forward guidance is typically conditional on certain expected macroeconomic developments. The dilemma then is how precisely is the conditionality to be communicated, and how to ensure that the market does not ignore the conditionality and interpret the guidance as an irrevocable commitment. In keeping with the best practice, we in the Reserve Bank too have started giving some forward guidance. And as expected, we too have confronted the classic communication dilemma. Let me illustrate. In the Second Quarter Review of early November 2010, we had said:
“Based purely on current growth and inflation trends, the Reserve Bank believes that the likelihood of further rate actions in the immediate future is relatively low. However, in an uncertain world, we need to be prepared to respond appropriately to shocks that may emanate from either the global or domestic environment.”
22. Many analysts commended us for the forward guidance, but a few thought that we were imprecise on the conditionality as well as on the time horizon implied by ‘immediate future’. I can only say that the element of ambiguity was deliberate because it was unavoidable.
(iii) Monetary Policy Stance - close to normal or closer to normal?
23. Let me give you another illustration of how we agonize over how every word might be interpreted. In the mid-quarter review of September 2010, as part of the forward guidance, we had said: “the Reserve Bank believes that the tightening that has been carried out over this period has taken the monetary situation close to normal”.
24. There were two communication dilemmas here. The first was whether we should say ‘close to’ or ‘closer to’. In the end, we determined that the forward guidance would be meaningful only if we had said ‘close to’, thereby giving ourselves room for further action. The second dilemma was about whether ‘normal’ would be interpreted as ‘neutral’. This dilemma arises in the context of the frequently asked question, ‘Have the policy rates become neutral?’ The neutral policy rate, as the economists here would know, is the policy interest rate consistent with potential growth and low and stable inflation. It is, however, not possible to precisely define the neutral rate for a rapidly growing and structurally transforming economy like that of India. On the other hand, ‘normal’ rates can be broadly inferred from the crest and trough of the policy rates over the growth-inflation cycle. In the post policy dissemination, we made an extra effort to communicate this distinction between ‘normal’ and ‘neutral’ rates.
(iv) Monetary Policy Stance - communicating uncertainty
25. A frequent dilemma we face is about how much of the uncertainty surrounding a policy decision we should communicate. Our policy decisions are based, among other criteria, on macroeconomic data, all of which is in the public domain. The media has more than enough expertise to interpret and analyze this data. Nonetheless, the market is eager to know the Reserve Bank’s interpretation of the data because, in the ultimate analysis, it is our interpretation that informs the policy decision.
26. To give you an example, the IIP (index of industrial production) data has been fluctuating in recent months bewildering analysts about the underlying trend and even raising doubts about the quality of the data itself. The market was understandably anxious about how the RBI might read the data. In order to let the market know that we do not know anything more than it does and to convey the extent of our uncertainty, in our September 2010 mid-quarter review we said ‘....the high volatility [of the IIP] over the past two months raises some doubts about how effectively the index reflects the underlying momentum in the industrial sector.’
(v) Disclosing inflation expectations survey
27. The Reserve Bank conducts a quarterly inflation expectations survey based on a sample of 4000 respondents spread over 12 cities including the four metros. We have been doing this since September 2005 and have gradually refined the survey methodology over time. Although the survey was originally intended to be an internal exercise to improve our appreciation of the inflation situation, by 2009 there was a growing view within the Reserve Bank that we should ‘communicate’ the survey results to the public on the principle that, as far as possible, there should be no information asymmetry between the public and us. We resolved that issue fairly quickly. We got the data quality and data analysis peer reviewed by a high level technical committee, and based on the committee’s endorsement, decided on disclosure.
28. The real communication dilemma was the one that followed, whether we will be able to convey the arms length relationship between the ‘Reserve Bank’ and the ‘Reserve Bank Survey’, and make the broader public appreciate that the survey results are the opinion of the respondents and not of the Reserve Bank. We made a serious effort to maintain that distinction. Initial reports showed that some segments of the public remain confused but we are hoping that that confusion will resolve in due course.
Communication Dilemmas Outside Monetary Policy Arena
29. As I said earlier, communication dilemmas arise not just in the domain of monetary policy but also with respect to other dimensions of the Reserve Bank’s work. Let me give you some illustrations from those.
(vi) Guidelines for new bank licences
30. As you know, there is a proposal to licence some new banks. The last time the Reserve Bank had formulated guidelines for bank licencing was way back in 2001; the world has changed a lot since then. We realized that the guidelines for bank licensing need to be revisited in the changed context. The broad issues in new bank licensing are by now quite familiar: the initial size of capital, the period to be allowed for capital dilution, conversion of NBFCs to banks or promotion of banks by NBFCs and the advisability of allowing corporates to start banks. On several of these issues, the world view has changed; many heresies of the past have become orthodoxies today.
2 “Post Crisis Reforms to Banking Regulation and Supervision - Think Global, Act Local”, Inaugural address by Dr. Duvvuri Subbarao, Governor, Reserve Bank of India, at the FICCI-IBA Conference on ‘Global Banking: Paradigm Shift’ at Mumbai on September 7, 2010.
31. We were eager to evaluate our bank licencing guidelines in the light of later experience and to get broadbased feedback from all stakeholders. Accordingly we decided to put out a discussion paper listing the pros and cons of each of the decision criteria. We were genuinely open minded and made deliberate effort to communicate our ‘open mindedness’. Most media and a majority of the analysts had thought we came across quite well on that count. But a small segment said that we had betrayed our ‘biases’ causing some consternation within the Reserve Bank. It is not clear whether we had fallen short in our communication effort or whether our interlocutors were superimposing their own prejudices in evaluating us. Regardless, there is a lesson here for us to improve our communication.
(vii) Basel III - getting the message across
32. As many of you know, the G-20, at its Seoul meeting in November 2010, endorsed the Basel III package for bank regulation and supervision. At the
