Interest rates to words, how monetary policy has changed
Monetary policy decisions, principally interest rates setting, used to be a behind-the-scenes activity. Nowadays, these processes are increasingly transparent, with central banks explaining their reasoning to investors and the general public. “As these communications become part of today’s 24-hour news cycle, investors’ reactions themselves influence how monetary policy impacts businesses and households,” explains Michael McMahon from the University of Oxford(opens in new window). While the setting of monetary policy and its impacts remains a prominent field within macroeconomics, analysis has typically focused on interest rates as the key tool. The NewMonEc(opens in new window) project, which was funded by the European Research Council(opens in new window), used computer science and natural language processing (NLP), alongside experimental methods, to investigate the effect of this recent shift in emphasis from interest rates to messaging. “Our methods and recommendations not only increase the effectiveness of monetary policies, but help maintain, and even enhance, trust in central banks,” adds McMahon.
Exploring the power of words in monetary policy messaging
NewMonEc was guided by two novel empirical methodologies: the adoption and development of NLP tools, complemented by experimental assessments of the impacts of different messaging on public understanding of monetary policy. In this era of increased transparency, data was sourced from information available on central bank websites, with NLP tools then used to analyse the messaging (as unstructured data) to identify and categorise key concepts. “This allowed us to study how policymakers’ uncertainty played out in their expressed policy preferences, particularly highlighting time variations in decision-making,” explains McMahon. “A key finding was that reducing the extent of conceptual complexity, such as using fewer technical economics terms, influences understanding and trust more than reduced semantic complexity, for instance using shorter sentences and more common words,” adds McMahon.
Contemporary relevance: understanding uncertain times
Monetary policy not only creates uncertainty for central banks but impels them to also react to it, and with the literature mainly focused on the former, NewMonEc set out to explore the latter. McMahon used the private deliberations of the Federal Reserve’s Federal Open Market Committee(opens in new window) (FOMC) – made public after five years – to quantify the perceived types uncertainty (by establishing indices of different types), correlated with the FOMC policy reactions in each case. “Contrary to common models of uncertainty policymaking, we argue that from the mid 1980s to 2015, the FOMC focused on concerns about the risk of rampant inflation. This vigilance, despite inflation generally being low and stable over this period, actually helped control it,” says McMahon.
Bridging the gap between citizens and technocrats
According to McMahon, while better policies benefit us all, as important is the ability to explain how the often seemingly arcane world of monetary policy, alongside its technocratic institutions, impact daily life. “While the European Central Bank has been conducting its strategy review, I gave a talk to over 300 European central bankers on communication with wider audiences, to ensure that NewMonEc’s recommendations about how better communication with a broader cross-section of society can be rolled out across the EU,” says McMahon. McMahon is now working on understanding the role of the media in transmitting economic messages to wide audiences, as well as further investigating how best to communicate issues related to economic uncertainty.