Central Bank Discretion, Credibility, and Expectations as a Key to Monetary Policy
“The explanation is that it is not the past rise in prices but the future rise that has to be counteracted” — Ralph George Hawtrey on forward-looking monetary policy (Monetary Reconstruction, 1923)
Expectations play an essential role for economic actors, especially the private sector, in making economic decisions. Expectations formed by economic actors are part of the rational choice of access to information on monetary policymaking by the Central Bank. In making monetary policy, the Central Bank has the value of promoting transparency to the public. One of the effects of this transparency is that it will affect the private sector’s expectations on macroeconomic variables in decision-making. Private-sector expectations are very important in helping or hindering the Central Bank’s accountability from achieving its goals. Therefore, to deal with this possible problem, the Central Bank can exercise discretion in making monetary policy so that economic actors can reduce the possibility of ‘bad’ expectations of inappropriate monetary policymaking by the Central Bank. The discretion by the Central Bank only makes economic actors optimistic in carrying out rational expectations in the short term because monetary policymakers will exercise discretion when they do not commit to economic stability policies in the long term.
Then, what is the reason behind monetary policy discretion by the Central Bank? The answer lies in producing a ‘good’ assessment of the expectations formed by economic actors in absorbing public information from the monetary policy measures taken. In the long run, this will cause problems with time-inconsistency; when economic actors consider monetary policymakers to override appropriate policy plans in the long term to make policy discretion in the short term in achieving economic stability. This is what makes the Central Bank’s policy discretion in the end face problems, so economists call it constrained discretion. To overcome the uncertainty over the expectations of economic actors caused by the policies of the Central Bank, the Central Bank can emphasize its commitment to its credibility role through the implementation of policies that have an anchor nominal value -namely nominal variables that are set to be a reference in policy objectives such as the inflation rate, the exchange rate, and the money supply. The credibility of this nominal anchor will help improve expectations of economic actors from the Central Bank’s policy discretion. Commitment to the Central Bank’s credibility on the nominal anchor value is a critical element to achieve the objectives of monetary policy, namely price stability and stability of economic activity.
The implementation of monetary policy discretion by the Central Bank to achieve short-term economic goals also requires ‘assessment’ from the public, which in turn shapes their expectations. Central Banks need to identify and implement robust monetary policy rules; monetary policy rules that focus on building a single reference model on outcomes economic variables. The implication of robust monetary policy rules affects the expectations of economic actors on the nominal anchor applied to monetary policy such as inflation, which will determine the outcome of the inflation rate of the monetary policy. The Central Bank does this with the aim of short-term price stability to dampen ‘bad’ public expectations of monetary policy control in the long term. On the other hand, the role of expectations in modern macroeconomic activities for the private sector is determined by how much information is obtained and knowledge of the magnitude of the expected impact on implementing monetary policy by the Central Bank. Economist Edmund Phelps contributed the famous thought with the term ‘The Phelps Programme in Macroeconomics’ where he considered that private sector agents faced asymmetric information problems in forming expectations, which then led to inefficiency and the inability of economic variables (Phelps gave an example of the unemployment rate) to reach equilibrium. According to him, companies and workers will absorb the information thoroughly and form their own decisions based on rational expectations before they conclude macroeconomic dimensions in the long run, such as prices and wages. If viewed from an individual perspective, the imperfection of knowledge and information forms the irrational expectations of private sector agents in responding to Central Bank policies.
From a modern macroeconomic perspective, apart from providing policy transparency to the public, the Central Bank should prioritize ‘communication’ as a tool to control people’s expectations. According to economist Benjamin Friedman, communication made by policymakers plays an essential role in the implementation of monetary policy. That way, economic actors, especially the private sector, have sufficient information to form more rational expectations on macroeconomic variables that will occur. One of the monetary policy frameworks formed by the Central Bank to make people’s expectations ‘better’ is the adoption of policies inflation-targeting. With the implementation of inflation-targeting, the Central Bank is directly committed to maintaining the inflation rate according to a predetermined threshold. This then encourages economic actors to form rational expectations in decision-making. In contrast to traditional monetary policy, which influences the expectations of economic actors indirectly by manipulating macroeconomic aggregates, this effort to adopt inflation-targeting by the Central Bank is used as one of the ways in modern monetary policy to determine policy effectiveness through the formation of a direct structure of expectations of economic actors. Thus, the formation of a rational structure of public expectations in monetary policymaking is a challenge in achieving the Central Bank’s credibility.
The ability of the Central Bank to plan the direction of inflation-targeting depends on the expectations of future inflation rates from economic actors, which is impossible without the current level of inflation. Therefore, the policy framework inflation-targeting includes a two-way time aspect for the future; namely to shape public expectations of future inflation rates, forecasting future inflation rates is used as a reference for policymaking at this time by making market operations through monetary policy an indicator of forming expectations of economic actors in the future. This then makes the Central Bank have a ‘conservative’ commitment to shaping the expectations of economic actors. For example, when the Central Bank can find out that economic actors are aware of its ‘sweet promise’ to be conservative in controlling inflation (usually by looking at the consumer satisfaction and confidence index), then the Central Bank does not have the sentiment to carry out an expansionary monetary policy which will increase expectations. Inflation of economic actors, thus making a trade-off between the inflation rate and unemployment in the short term.
Based on the description above, the availability of perfect information from the implementation of monetary policy by the Central Bank through the principles of transparency and communication will form rational expectations among economic actors. Transparency and communication by the Central Bank are needed to reduce asymmetric information by providing guarantees for providing information to the public regarding macroeconomic uncertainty in the short term and providing detailed information on economic developments from time to time to avoid problems time-inconsistency and making monetary policy planning easier. Easier and more effective. Both transparency and further communication will increase the credibility and accountability of the Central Bank in making monetary policy, thus forming the expectations of rational economic actors.
References
Demertzis, M. (2011). The Role of Expectations in Monetary Policy. SSRN Electronic Journal, 31(20), 1–17. https://doi.org/10.2139/ssrn.934501
Walter, T. (2019). Formalizing the future: How central banks set out to govern expectations but ended up (en-)trapped in indicators. Historical Social Research, 44(2), 103–130. https://doi.org/10.12759/hsr.44.2019.2.103-130
Levin, A. T., & Williams, J. C. (2011). Robust Monetary Policy with Competing Reference Models. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.530862
Mishkin, F. s. (2019). The Economics of Money, Banking, and Financial Markets (Global Edition). Pearson. https://doi.org/10.4135/9781452281995.n12
