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…Warns against fixed rate promises
The International Monetary Fund (IMF) has urged central banks to rethink how they communicate monetary policy, warning that committing to fixed interest-rate paths could become costly in an increasingly uncertain and shock-prone global economy.
The IMF said central banks should focus more on explaining how they would respond to changing economic conditions and incoming data, rather than giving markets firm indications of where interest rates are headed.
The recommendation was contained in a blog post published on Wednesday by Tobias Adrian, the IMF’s Financial Counsellor and Director of its Monetary and Capital Markets Department.
According to the IMF, frequent and faster-moving economic shocks, combined with high uncertainty and instant market reactions, have made central bank communication more challenging.
It said policymakers needed to clearly explain their objectives, the factors guiding their decisions and how risks could affect policy under different economic scenarios.
The Fund noted that central banks had traditionally relied heavily on “forward guidance”, particularly after the global financial crisis, by signalling or committing to a likely future path for interest rates.
While that approach could be effective when interest rates were stuck near their lower limits and inflation expectations were falling, the IMF said such commitments could create problems when economic conditions suddenly changed.
“Supply shocks, inflation surprises, or abrupt shifts in the balance of risks may require policymakers to adjust course,” the IMF said.
It said communication had consequently shifted towards explaining how monetary policy would respond as economic conditions evolved and new data became available.
The IMF said central banks should do more to explain their “reaction function”, how policymakers interpret economic data, assess risks and balance competing policy objectives.
It identified underlying inflation, inflation expectations and the effectiveness of monetary policy transmission as key factors that influence policy decisions.
The Fund said the increasing emphasis on “data dependence” was aimed at helping the public and financial markets understand which economic indicators matter and how they could influence future policy decisions.
It also cautioned central banks against presenting economic forecasts as promises.
“Forecasts are not promises,” the IMF said, warning that precise forecasts or interest-rate projections could be mistaken for firm commitments.
According to the Fund, scenarios could instead be used to show how monetary policy might respond to different economic outcomes while making it clear that future decisions would depend on incoming data.
The IMF recommended that forecasts should be accompanied by clear explanations of risks, while any commitments on interest-rate paths should be exceptional, conditional and subject to clearly stated escape clauses.
The Fund also warned that more communication does not necessarily mean better communication.
With social media, automated news analysis and artificial intelligence allowing markets to process central bank statements almost instantly, excessive detail could cause investors to focus too much on interpreting every word from policymakers instead of assessing broader economic fundamentals.
The IMF said the objective of central bank communication should not be to eliminate market volatility.
Rather, it should reduce uncertainty about how policymakers are likely to respond to new information and minimise unexpected policy moves.
The Fund noted that some volatility was useful because changes in asset prices in response to new economic information help markets perform their price-discovery function.
It urged central banks to communicate with greater humility by clearly setting out their policy objectives, decision-making process, forecasts and the risks surrounding their economic outlook.
“Given the high degree of uncertainty globally, central banks need to be explicit about risks,” the IMF said, stressing that communication should accurately reflect the level of uncertainty facing the economy.
