Banks tiptoe through an etymological minefield

Published in the Financial Times on March 22, 2004

Stephen Cecchetti Professor at the Brandeis International Business School

Communication is a difficult business. Most of us spend comparatively little time thinking about what we say and when we say it. Central bankers do not have that luxury. They need to choose words carefully. Even so, policymakers should be prudent enough to ensure that no individual word has too much weight. Over several years, the Federal open market committee has faced significant challenges. Low inflation and high growth testify to the success of interest rate policy, but the communication strategy has created problems. In January, just a few words triggered large and sudden market movements in a way that served no useful purpose.

The story is now familiar. With the Fed funds rate target at 1 per cent, the committee had little room to ease monetary conditions through conventional means of reducing short-term interest rates. The solution was to use words to lower long-term rates. The statement after the FOMC's meeting on August 12 last year said: "In these circumstances, the committee believes that policy accommodation can be maintained for a considerable period."

For three subsequent meetings, the FOMC retained the phrase "considerable period" in its statements. In its January meeting, however, the wording changed - despite predictions to the contrary by Fed watchers. The new statement omitted the phrase "considerable period". It said: "The committee believes that it can be patient in removing its policy accommodation."

The reaction was immediate: bond prices plummeted as financial market participants, reading the change as a signal that interest rate increases were on their way, moved to drive up rates right away.

Episodes such as this are bad for everyone - not just traders with losing positions. Miscommunication creates volatility and in a world where policymakers' statements bounce interest rates around regularly, we all end up paying the price for noisy central bank communication.

What should the FOMC do? The most obvious option is, nothing. Given how conservative central bankers generally are, this would surely appeal to the committee members. But there are two other alternatives.

The fundamental problem is that the words in FOMC statements have become extremely valuable. This is evident from the committee's lengthy discussion about changing the language before its January statement. One option would be to cut the number of words, which would increase their value even more; another would be to increase the number of words, thereby reducing the value of each one.

From looking at other central banks' strategies, there seem to be two natural possibilities. First is the Bank of England strategy of publishing a short announcement of the interest rate decision, followed two weeks later by minutes of the monetary policy committee's meeting. By contrast, the European Central Bank issues a lengthy statement of more than 1,000 words after each policy meeting and then the president and vice-president hold a news conference.

It is hard to conceive of the Fed chairman holding a news conference after each FOMC meeting, and easier to imagine the minutes of each meeting being released a little earlier, say 10 to 14 days after. This would merely require accelerating the existing procedure, under which minutes are prepared for release after the committee's next meeting.

A careful reading of the published minutes from the FOMC's January meeting shows the benefits of early release. We now know that some committee members are uncomfortable with the low level of the Fed funds rate and have become concerned that inflation may start rising in the near future. From the reported details of the discussion we can see that the same people will possibly argue for tightening in the near future.

This split over inflation prospects is the likely source of the change from "considerable period" to "patient" - a change portrayed as increasing near-term flexibility. Surely we would have been better off understanding this a month ago?

The point is that the FOMC'S 100-word statement is the worst option at times we most need insight. It seems much less risky to use more words than fewer to give that insight - in other words, to dilute the impact of individual words. Earlier release of the meeting minutes would do exactly that.

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