In fact, economists do not fully understand how markets incorporate information. Herding behavior, information cascades, multiple equilibria, and the amount of investment in financial research all pose puzzles about markets and information. The situation is complicated still more when an important participant is seen as having superior information owing to its investment in research or its understanding of its own behavior. In such circumstances, certain types of central bank talk might actually impinge on welfare-enhancing market pricing by being misunderstood and receiving too much weight relative to private judgments.

We're going to have to raise and lower interest rates more frequently than you might otherwise think because, even if inflation doesn't wiggle around, we're just going to have to be vigilant...That's a statement apart from the current (tightening) cycle.

Under the forecast-based approach, in contrast, the public will generally find inferring the likely course of policy to be a great deal more difficult. In that regime, policy plans depend in a complex way on policymakers' outlooks, risk assessments, and objectives, which the public is unlikely to deduce accurately without guidance. Clear communication thus appears to be especially important for central banks that employ a forecast-based approach to policy--a category that includes most contemporary central banks, including the Federal Reserve.

[O]pen and clear communication by the policy committee--which in practice includes speeches and congressional testimony by FOMC members, as well as official statements--makes monetary policy more effective in at least three distinct ways.

First, in the very short run, clear communication helps to increase the near-term predictability of FOMC rate decisions, which reduces risk and volatility in financial markets and allows for smoother adjustment of the economy to rate changes...

Second, in the long run, communicating the central bank's objectives and policy strategies can help to anchor the public's long-term expectations--most importantly, its expectations of inflation...

The third way in which clear and open communication enhances the effectiveness of monetary policy--the channel that will be the focus of my remarks today--is by helping to align financial-market participants' expectations about the future course of monetary policy more closely with the policy committee's own plans and projections. As I will discuss, to the extent that central bank talk provides useful guidance to markets about the likely future path of short-term interest rates, policymakers will exert greater influence over the longer-term interest rates that most matter for spending decisions. At the same time, expanding the information available to financial-market participants improves the efficiency and accuracy of asset pricing. Both of these factors enhance the effectiveness and precision of monetary policy.

Most recently, the Committee has introduced additional commentary on the outlook for policy into its statement. For example, the August 2003 statement of the FOMC indicated that "policy accommodation can be maintained for a considerable period," a formulation replaced a few meetings later with the comment that the Committee could be "patient" in removing policy accommodation. These statements conveyed information to markets about the Committee's economic outlook as well as its policy approach. .. The language of the statement in August 2003 and subsequent meetings persuaded the markets that an autumn tightening was not in the cards, and market expectations adjusted accordingly. Crucially, this change in expectations resulted in lower interest rates at all maturities, a development that helped support the expansion in the latter part of last year.

My own view is that we are approaching the limits of purely qualitative communication and should consider the inclusion of quantitative information presented in a clearly specified framework. For example, like policymakers at many other central banks, the FOMC could specify its long-term inflation objective and include explicit economic forecasts, conditioned on alternative assumptions, in its statements or in regular reports. That being said, one must recognize that the FOMC is not a "unitary actor," as the political scientists term it, but a committee of nineteen highly independent people. With the best will in the world, achieving a Committee consensus on a detailed forecast (for example) will always be difficult in the short time available. Some ambiguity in the FOMC's communications may therefore be unavoidable.

More controversially, the FOMC might consider forecasting future values of the short-term interest rate, as is currently done by the Reserve Bank of New Zealand. The difficulty would be to make clear that an interest-rate forecast is not the same as a policy commitment. The use of "fan charts" to indicate the range of uncertainty would be helpful in this regard; and indeed, providing more information about the range of uncertainty for all FOMC forecasts would be a useful innovation.

Can central bank talk--Fedspeak, in the vernacular of the U.S. media and financial markets--make monetary policy more effective and improve economic outcomes? To see why communication may be an integral part of good monetary policymaking, recall that the Federal Reserve directly controls only a single short-term interest rate, the overnight federal funds rate. Relative to the enormous size of global financial markets, the market for federal funds--the market in which commercial banks borrow and lend reserves on a short-term basis--is insignificant. Control of the federal funds rate is therefore useful only to the extent that it can be used as a lever to influence more important asset prices and yields--stock prices, government and corporate bond yields, mortgage rates--which in turn allow the Fed to affect the overall course of the economy.

Today I would like to share my own thoughts on the prospect of an "unwelcome substantial fall in inflation"--in particular, why a substantial fall in inflation going forward would indeed be unwelcome; why some risk of further disinflation, though "minor," should not be ignored; and what such a fall would imply for the conduct of monetary policy...

Let's first be clear what we are talking about. Some in the media apparently interpreted the May 6 statement as saying that the Federal Reserve anticipated imminent deflation in the United States and informed the public accordingly. In my view, such an interpretation substantially overstates the concerns that the FOMC intended to communicate with its statement. First, we have no reason to think that a drastic change in the inflation rate is imminent...

This distinction between inflation that is positive yet too low and deflation is worth exploring for a moment. Although the Federal Reserve does not have an explicit numerical target range for measured inflation, FOMC behavior and rhetoric have suggested to many observers that the Committee does have an implicit preferred range for inflation. Most relevant here, the bottom of that preferred range clearly seems to be a value greater than zero measured inflation, at least 1 percent per year or so.

Ambiguity has its uses but mostly in noncooperative games like poker. Monetary policy is a cooperative game. The whole point is to get financial markets on our side and for them to do some of our work for us. In an environment of low inflation and low interest rates, we need to seek ever greater clarity of communication to the markets and to the public.

The public has a right to know what its unelected, as well as elected, officials are doing, and why. And this is the reason that transparency is so important for supporting the independence of the central bank. Transparency facilitates a broad understanding of what the central bank is doing and thereby gives the public the tools to hold the independent central bank accountable. Transparency, in fact, can play a valuable role in reinforcing the institutional independence of a central bank

If the monetary authority can be clearer about what it is doing now and what it plans to do--not in the sense of setting future moves in stone, but rather in terms of explaining risks that might influence future policy--then market participants can improve their expectations of future short rates. Also, less uncertainty about monetary policy might reduce the premium for uncertainty. Thus, transparency ought to bring the rates that matter most for the macroeconomy into closer alignment with the intentions of monetary policymakers. In effect, greater transparency allows policymakers to work with the market, not against it.

If the public is unclear about the strategy and objectives of the central bank, the credibility of monetary policy may suffer. Current economic developments or policy actions directed toward short-run concerns could have an outsized influence on perceptions regarding the more distant future--especially long-run inflation expectations and, therefore, long-term interest rates. Because such changes in perceptions could be counterproductive, concern about triggering them might discourage a central bank from taking action that otherwise could have been appropriate and beneficial for the economy in the near term. Lack of transparency and lack of credibility, in this sense, could reduce the effectiveness of monetary policy in stabilizing the economy against transitory shocks.

At the risk of being somewhat unpleasant, I’d also like to say that I think we have a particular problem at the moment. This is a time when it is highly vital that we get all the information we can, but that is being made somewhat difficult by the fact that we are looking at ourselves in the mirror because of what I view as too many statements by Fed officials. We are all in a position where making statements about policy is a temptation. But let me suggest that that is something we don’t have to do. If I can hold myself up as an example, there was a Dow-Jones report yesterday about my comments at a conference sponsored by the U.K. Financial Services Authority. The report said that my remarks “largely repeated recent speeches on the Basle Accord, but failed to touch on the U.S. economy. McDonough, a voting member of the Federal Open Market Committee, declined to discuss monetary policy with reporters.” Now, other than patting myself on the back for virtue, there is a reason I raise this point. Even though we may believe that a recovery in the second half of the year is likely, when we say that publicly a degree of certainty is being postulated that I find very troublesome. It makes it difficult for the Federal Reserve to move if we decide in this period that we wish to do so. More generally, this is the time of year when I think one should be honoring Passover and the Christian holidays and I believe that in both of those religions silence is considered a great virtue.

In light of these difficulties, the first priority of the MPC might be to improve the clarity and usefulness of its current forecast made under constant interest rates. To further aid the public in forming expectations about future interest rate changes, the Committee might consider extending the forecast beyond two years either formally in the fan chart, or informally in a discussion of tendencies. Such an extension, together with information about the risks to the forecast, should help the public make informed judgments about the likely course of interest rates. In addition, the Committee might encourage research on how it could determine and publish any views it had about the possible future evolution of the policy rate.