Home / Opinion / The importance of policy predictability

Soon after taking over as chairman of the Federal Reserve in 1987, Alan Greenspan famously said that he had learned to “mumble with great incoherence". Greenspan was not alone among his peers to have mastered this dark art. Until the early 1990s, the conventional wisdom among central bankers was that they should be cryptic while speaking in public, and say as little as possible.

But things have changed since then. Communication has now become an important tool in conducting monetary policy in most countries. Clear communication has helped in managing market expectations, especially in the aftermath of the global financial crisis, and was instrumental in restoring order in financial markets. Greater focus on transparency, communication and guidance by central banks has resulted in greater policy predictability.

However, given the state of the financial system and the role that the accommodative policy in advanced economies has played in pushing up asset prices, an alternate emerging view is that policy decisions are being dominated by sources such as financial markets. The Reserve Bank of India (RBI) in its latest Financial Stability Report also raised this issue and noted: “…there is a need to rethink whether the central banks should always act in a predictable way and never surprise the markets. It is, therefore, important to assess the costs and benefits of too much assurance to markets."

The importance of predictability in monetary policy can perhaps not be overstated. In the summer of 2013, Ben Bernanke, then chairman of the Federal Reserve, surprised the market by indicating that the US central bank could start reducing the quantum of asset purchases, or quantitative easing. Consequently, financial markets all over the world went into a tailspin. India was severely affected by this taper talk and the rupee was in a freefall, though domestic macroeconomic conditions were also to be blamed for a near-crisis situation.

Raghuram Rajan, after taking over as governor of RBI in September 2013 when India was still struggling with taper tantrum volatility, also emphasized the need for transparency and predictability in policy—though he added that this does not mean that the central bank will never surprise the market. RBI indeed surprised the market with out-of-turn cuts in policy rates in 2015. This only resulted in confusion among market participants. Monetary policy stance in India has now become more predictable with the adoption of inflation targeting.

At the global level, predictability in monetary policy path and better communication by central banks have helped economic agents make informed financial decisions. It is difficult to argue that bringing in some unpredictability or surprising the market will help central banks achieve policy objectives, including that of maintaining financial stability.

The problem with monetary policy in the industrial world is certainly not one of assurance to the market. The Federal Reserve was actually able to end quantitative easing and eventually raise interest rates without much trouble, simply because markets knew the stance and the path of the central bank. Had the Federal Reserve decided to end easing and raise rates when Bernanke first aired the idea of the taper, things could have become very ugly for both the financial market and the global economy.

To be sure, the problem with monetary policy is much deeper.

Central banks have done most of the heavy lifting in the aftermath of the financial crisis and have stretched the limits of what monetary policy can do. As a result, return on increasing accommodation has been diminishing and channels of monetary transmission are not working as desired. Policy surprises at this stage will neither help the economy nor enhance the credibility of central banks. What is perhaps needed is re-examination of the policy path that central banks have taken, preferably in a coordinated fashion, so that excesses in financial market and elsewhere can be avoided. Central banks would do well to reserve policy surprises for extreme circumstances. It should be used to quell instability and not to induce volatility. It is possible to make policy changes in a predictable manner, as has been shown by the Federal Reserve.

Should central banks surprise the market often? Tell us at views@livemint.com

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