Central Bank Communication and the Term Structure

September 16, 2017

It’s a choice between being surprised by immediate small changes, and being surprised by warnings of much bigger future changes. A simple and maybe obvious point. I don’t know if it’s been made before; if not, it should have been.

The Bank of Canada has eight Fixed Announcements Dates per year. At each FAD it announces its target for the overnight rate of interest until the next FAD.

Suppose the Bank of Canada did it differently. At each FAD it announces the overnight rate target for the following FAD. This would give financial market participants 6.5 weeks advanced warning of any change in the overnight rate.

I think I am right in saying that financial market participants in general, and the commercial banks in particular, would prefer that second way of implementing monetary policy. I think they would say that it is a better communications strategy, with greater transparency. I think what they mean is that they don’t like being surprised, and prefer to have advanced warning of any changes in the overnight rate, which is perfectly understandable.

But why stop there? Wouldn’t it be better still if the Bank of Canada announced at each FAD what it would do at the FAD after the next, so everyone would get 13 weeks advanced warning of any change in the overnight rate?

But why stop there? And so on.

In the limit, when the Bank of Canada first introduced the 2% inflation target, it should have announced the whole time-path for the overnight rate target from then until eternity. Which is a contradiction, because it wouldn’t be able to hit its inflation target if it couldn’t ever adjust its monetary policy instrument.

It’s tempting to say that it’s like asking the driver of a car to give the passengers advanced warning before moving the steering wheel, which makes the driver’s job of keeping the car on the road much harder. But that analogy is not quite accurate. Because the economy is like a car whose direction depends not just on the current position of the steering wheel but on the car’s expectation of the future position of the steering wheel.

In the simplest case (the pure expectations hypothesis) the current two year interest rate is equal to the (geometric) average of the current one-year interest rate and the expected one-year interest rate for next year. So by announcing changes in the interest rate one year in advance, the Bank of Canada would be able to influence all current interest rates for terms greater than one year, but not less than one year. The longer the advanced warning, the smaller the subset of the term-structure of interest rates the Bank of Canada can influence. And if Aggregate Demand depends on the whole term-structure of interest rates, from shortest to longest, the smaller the subset it can influence, the bigger the change in the overnight rate that will be needed to have the same effect on Aggregate Demand.

Take a simple example to illustrate my point. Suppose Aggregate Demand depends equally on the one-period interest rate and the two-period interest rate, and the two-period interest rate is the simple average of the current one-period and expected future one-period rates. And suppose the economy is hit with random shocks that are permanent (the natural rate r* is a random walk). If the Bank of Canada changes the one-period interest rate immediately it observes a 1% shock to r*, it changes the one-period rate by the same 1%, and the two-period rate changes by the same 1% (because everyone knows that shocks to r* are permanent). But if the Bank of Canada has to give one period’s advanced warning, it needs to change the current two-period rate by 2% (since it cannot change the one-period rate), and it needs to announce a change of 4% in the future one-period rate (since you need to change the expected future rate by twice as much as you want to change the two-period rate). And in the following period, if there are no additional changes to r*, it announces a future cut of 3%.

It gets even hairier if changes to r* are transitory. I will leave that as an exercise for the reader.

Your call, financial market participants who don’t like surprises.

[We could talk about conditional commitments, where the Bank of Canada announces in advance what it will do, conditional on future data. But that inevitably leads to the Bank of Canada committing itself to an instrument rule (like the Taylor Rule for example). Which opens up another can of worms. So I will leave that aside.]

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