Monday, January 16, 2012

Clarity of Central Bank Communication About Inflation

This paper examines whether the clarity of central bank communication about inflation has changed with the economic environment. We use readability statistics and content analysis to study the clarity of communication on the inflation outlook by seven central banks between 1997 and 2010. Overall, we find no strong indications that central banks were less clear in explaining their policies when faced with higher uncertainty or a less favorable inflation outlook. The global financial crisis, however, did have a negative impact on clarity of central bank communication.

This paper studies the clarity of communication by central banks, in particular their communication on the inflation outlook. Communication is an integral element of monetary policy in many developed and emerging economies. Indeed, central banks have made great efforts to increase their transparency and accountability to the public (Eijffinger and Geraats, 2006; Dincer and Eichengreen, 2007). Central banks provide a greater volume of information and communicate through a range of channels – including inflation reports, press releases, and press conferences – and this information tends to be available faster, more frequently, and to wider audiences than ever before. Previous research has identified various benefits of the increase in communication such as higher predictability of interest rate decisions (e.g., Woodford, 2005; Blinder and others, 2008).

Little is known, however, about how clear central banks’ communication is, and what factors drive changes in clarity over time. Recent studies suggest that central banks have not always provided a clear message (Bulíř and others, 2008; Bulíř, Čihák, and Šmídková, forthcoming). In these papers, central banks in a sample of developed and emerging market countries were found to be clear on average between 60 percent and 95 percent of the time. But why have some communications been clear while others are not? Can these variations in clarity be explained? So far, this has not been extensively researched.

Communication clarity and changes therein should be relevant for policymakers, as the quality of communication on the inflation outlook affects the degree to which inflation expectations can be managed. Or, as Blinder (2009) puts it:

“Since clearer communications presumably have higher signal-to-noise ratios, they should in principle convey more information. (…) While the clarity issue has received scant attention in the literature, I find it tantalising that (…) different methodologies come to the same conclusion: that greater clarity enhances the quality of central bank communication. I would love to jump to this conclusion, but it so far rests on a slender evidentiary base. More research on this issue would be welcome.”

Our aim is to fill this gap, that is, to explain variations in the clarity of central bank communication. In particular, does the clarity of central bank communication depend on the context? Is clarity sensitive to the inflation outlook or uncertainty therein, or both?

To motivate why uncertainty in the inflation outlook can influence clarity, imagine writing inflation reports in two different scenarios. The first scenario is straightforward: persistent monetization of debt has resulted in high inflation, and this policy is widely expected to continue. In the second scenario, assume there are many factors, some difficult to measure precisely, and some offsetting each other. On the one hand, there is relatively less to gain from “crafting the message” in the first scenario, because the causes of inflation are obvious and likely to continue; on the other hand, delivering a clear message is relatively easy. In the second economy, the potential gains from a well-crafted message are substantial; however, delivering a clear message is more challenging. In essence, we try to find out whether the communication effort is reflected in additional clarity during complex economic situations.

Our initial hypothesis is that when the inflation outlook is less certain, or less favorable, communication will be more difficult for the central bank, leading to less clarity. More uncertainty is typically associated with more explanatory factors and more challenges when measuring these factors and communicating their impact on the inflation outlook. Admittedly, in situations of greater uncertainty, the clarity of the central bank’s message yields a higher return. The central bank may be well aware that, in some cases, clear explanations are expected. If it then invests more heavily in the drafting process, clarity may well remain unchanged, or it may even increase. We are not aware of research that has sought to investigate this issue empirically.2

It is important to understand the drivers of communication clarity, for two main reasons. First, as argued by Jansen (2011a), clarity is an important pre-condition for transparency. Even if a central bank communicates frequently, but does so opaquely, it can hardly be called transparent. Second, clarity may carry direct benefits. As noted by Blinder (2009), clearer communication has a higher signal-to-noise ratio and carries more information. So far, there has been little work to investigate this hypothesis empirically, but the evidence at hand does suggest that clarity is beneficial. Fracasso, Genberg and Wyplosz (2003) have found that well-written inflation reports are associated with higher predictability of decisions. Jansen (2011b) finds that greater clarity of the Humphrey-Hawkins testimonies by the Fed chairman has gone hand in hand with lower volatility in financial markets.

Our paper makes several contributions to the literature. First, we use a measure for clarity which is standard in many fields, such as linguistics or psychology, but has not often been used by economists. One benefit of this criterion is its objectivity, as it only uses textual characteristics: the number of words, sentences, and syllables. As an alternative measure of clarity, we also use the length of the reports. Second, using this measure, we are able to document how clarity of various types of communications by seven central banks has evolved over the last decade. Third, we analyze if and how clarity has been related to the context in which communications were made. In particular, we study how inflation outlook and the uncertainty around the outlook affected clarity.

To preview our findings, we uncover significant and persistent differences in clarity over time and across countries. Readability appears to be country

While some countries’ inflation reports have become more readable over time (Chile, Sweden, and the United Kingdom), in other countries readability worsened (Thailand).

Regarding our main hypothesis, overall, we find little evidence that central banks were less able to clearly explain their policies when faced with higher uncertainty or a less favorable inflation outlook. Short-term fluctuations in clarity are hard to account for, although the central bank’s assessment of inflation and dissent in voting on interest rates explain some of the variation. Finally, we find that the global financial crisis contributed to making central bank communication less clear. This indicates that—while central bank communication has generally been successful in adapting to new contexts—the financial crisis provided a major communication challenge.

The remainder of the paper is organized as follows. Section II outlines the data and estimation approach. Section III presents results for the clarity of inflation reports, press releases and statements, and report length. Section IV concludes

IMF. Author/Editor:Bulir, Ales; Cihák, Martin; Jansen, David-Jan


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