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1 August 2014 CFA Institute Journal Review

Communications Challenges for Multi-Tasking Central Banks: Evidence, Implications (Digest Summary)

  1. Jakub M. Szudejko, CFA

Monetary policy is commonly associated with a predictable relationship between inflation and output gaps, which would result in financial stability. The author explains how central banks can meet their objectives and prevent future financial crises by adopting a hybrid policy of inflation and price level targeting.

What’s Inside?

The author investigates the transparency of monetary policy communication by central banks and evaluates their ability to ensure financial stability. His findings confirm that central banks effectively communicate a price stability objective but that the current policy of inflation targeting is not fit to deal with financial stability issues. Based on his research, the author proposes a hybrid communication framework that emphasizes both inflation and asset price level targeting.

How Is This Research Useful to Practitioners?

The transparency of central banks is crucial to meet their objectives, and effective communication serves as a tool to influence market expectations. The author finds that the monetary policy transparency level depends on clear communication about economic outlook, the policy strategy, and the decision-making process.

Central banks are responsible for both monetary policy and financial stability goals, which are particularly important in the post-crisis world. The author notes that it is challenging to define and communicate financial stability goals because they are not easily described in numerical terms. Furthermore, the objectives of central banks may conflict with one another. In periods of poor economic conditions, imbalances in asset pricing (e.g., real estate or stock bubbles) require tight monetary policy.

Next, the author finds that the relationship between inflation targeting and financial stability is not consistently statistically significant. Not all transparency characteristics improve financial stability; therefore, central banks should focus on multitasking. The author concludes that central banks should implement a hybrid inflation target approach, which would allow them to target asset prices as well as drift away from an inflation target to correct the asset pricing imbalance during extraordinary times.

Because of the limited effectiveness of traditional tools, the author recommends that central banks collaborate with other regulators and jointly communicate their common purpose to ensure that macroprudential goals are met.

How Did the Author Conduct This Research?

The study is based on data from Bank for International Settlements (BIS) surveys of 30 central banks, with a focus on industrial economies.

The author builds a transparency index that aggregates 15 central bank attributes subdivided into five categories: political, economic, procedural, policy, and operational transparency. He uses a factor model to measure the level of transparency of each central bank with respect to each characteristic.

Using a regression of BIS survey responses and key macroeconomic measures, the author introduces a financial stability index, with emphasis on the inflation target and price stability. The variance of errors in inflation forecasts is based on Consensus Economics data from 1997 to 2007. A larger variance is assumed to be a proxy for financial and inflation instability.

Furthermore, for central banks that adopt a numerical inflation target, the author measures inflation forecast disagreement, using squared deviations of forecasts relative to a mean forecast. He assumes that greater disagreement over forecasts is related to greater financial instability. Finally, the author constructs another financial system stability proxy that aggregates World Bank data on capital adequacy, nonperforming loans, domestic credit to GDP, and lending risk premium.

Despite a relatively small sample size and information complexity, the author attempts to ensure that the conclusions are valid through the use of additional controls and a t-test to confirm the statistical significance of each coefficient.

Abstractor’s Viewpoint

The author explains why central banks of industrial economies are relatively good at keeping inflation within the target and relatively poor at maintaining financial stability and foreseeing financial crises. Ensuring both price and financial stability goals may be difficult, particularly because central banks may attempt to return to higher interest rates.

The research is useful for central bankers who may wish to revise their communication framework and for academics who could further study this subject.

The study is comprehensive, but the addition of analysis of other proxies for financial stability (e.g., sovereign credit spread) and the use of the most recent data would make it even more relevant.

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