Monetary policy: Open-Market Operations or Open-Mouth Operations?


By Paul Hubert

Can the communications of a central banker influence agents’ expectations in the same way as they change interest rates? To believe Ben Bernanke, the answer is yes.

In a speech on 18 October 2011, Ben Bernanke, governor of the US central bank, highlighted his interest in finding new tools to help businesses and consumers anticipate the future direction of monetary policy. Thus we learn that the bank’s Federal Open Market Committee (FOMC) is exploring ways to make its macroeconomic forecasts more transparent. Indeed, if the publication of the forecasts influences the formation of private expectations about the future, then this could be treated as another tool of monetary policy.

It is worth pointing out that the impact of communicating the central bank’s forecasts depends on the bank’s credibility. Any impact that the publication of the forecasts has on the economy is neither binding nor mechanical, but rather is channelled through the confidence that businesses and consumers place in the statements of the central bank. So if a statement is credible, then the action announced may not be needed any more or its amplitude may be reduced. The mechanism is straightforward: publishing the forecast changes private expectations, which in turn modifies decision-making and therefore the economic variables. Ben Bernanke’s determination to implement what he calls “forward policy guidanceand the emphasis he is giving to the importance of the central bank’s forecasts suggest that the Fed is seeking to use its forecasts as another instrument to implement its monetary policy more effectively.

Based on the inflation expectations of private agents collected through quarterly surveys called the Survey of Professional Forecasters (available here), it appears that the FOMC inflation forecasts, published twice yearly since 1979, have a persistent positive effect on private expectations (see the working document). Expectations rise by 0.7 percentage point when the Fed increases its forecast by one percentage point. Two interpretations of this effect could be offered: by raising its forecast, the Fed influences expectations and in a certain sense creates 0.7 percentage point of inflation. The effectiveness of such an announcement would therefore be questionable. In contrast, it is conceivable that an increase of 1 percentage point of inflation will occur and that by announcing it, the Fed sends a signal to private agents. They then expect a response from the Fed to counter the increase, and so reduce their expectation of the increase. The Fed’s communication would therefore have succeeded in preventing a 0.3 percentage point increase in future inflation, meaning that the announcement has been effective.

This last mechanism, called “Open-Mouth Operations” in an article published in 2000 dealing with the central bank of New Zealand, would therefore act as a complement to the bank’s open market operations that are intended to modify the central bank’s key rates so as to influence the economy.

In order to shed light on the reasons why private expectations have increased, it would help to characterize the mechanisms underlying the influence of the FOMC forecasts. If the FOMC forecasts are a good leading indicator of the Fed’s future key rates, they provide information about future decisions. It appears from this study that an increase in the FOMC forecasts signals that there will be an increase in the Fed’s key rates 18 to 24 months later.

Furthermore, the FOMC forecasts do not have the same impact as the bank’s key rates on macroeconomic variables, nor do they respond in the same way to macroeconomic shocks: the responses of key rates to macroeconomic shocks are substantial and rapid in comparison with the responses of the forecasts. This suggests that the FOMC forecasts are an a priori instrument intended to implement monetary policy over the long term, whereas the key rates are an a posteriori instrument that responds to shocks to the economy, and thus to the short-term cycle.