A new year’s resolution for central bankers

Unlock the Editor’s Digest for free

Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.

The writer is head of macro research at BNP Paribas Asset Management

It is getting towards the time when many start turning to resolutions for the new year. Here is a suggestion for the people who set interest rates: publish your estimates of where you expect rates to settle in the medium run.

Policymakers are often asked about the location of that so-called neutral rate, but they rarely give a precise answer. At present, the default response is that rates are currently above neutral, but it is very hard to know by how much. Many policymakers are reticent about providing point estimates of what they consider a highly uncertain, unobservable model-based concept. Nonetheless, the arguments for talking more about neutral rates are compelling.

The neutral rate is the level of the policy rate that is required to keep demand rising in line with supply in the medium run. It is not a fixed number. The neutral level will move to offset any shock that can persistently and significantly affect spending in the economy. Your estimate of neutral is therefore a good summary statistic of your medium-term forecast for spending and the forces that shape it: changes in the fiscal stance, economic uncertainty, overseas demand for exports and so on.

The location of the neutral rate is a key ingredient in the policy debate. So policymakers should have an insatiable demand for estimates of neutral. You need to know whether the current policy rate is “tight” (above neutral) or “loose” (below) — ie, is policy suppressing or stimulating spending? — and by how much, if you want to accurately estimate the impact of the policy rate on the economy. The decision to publish an estimate of neutral will focus minds and resources within central banks on refining that estimate, to the benefit of the policy debate.

Talking about the location of neutral should help policymakers in their pursuit of economic stability too. Expectations of the future path of rates influence broad monetary and financial conditions — such as the level of fixed-rate mortgages or the value of the currency — which in turn shape the path of spending in the economy. Providing quantitative estimates of neutral could help to anchor those expectations of the policy rate in the right place, damping the volatility of broad monetary and financial conditions and ultimately stabilising spending.

Otherwise, policymakers can find themselves inadvertently validating the current market view on neutral in the current set-up. Central bank forecasts are typically conditioned on the assumption that rates follow the path expected by investors. If those forecasts show growth close to trend at the end of the forecast horizon — as they often do — then investors can reasonably infer that the central bank shares the market’s view on the location of neutral. Policymakers might wish to reflect on whether they want to send that signal.

Neutral rate estimates will often turn out to be wrong. That is not an excuse to not publish them. Central bank reputations are based on getting the big decisions right, not the accuracy of the estimates they publish. Transparency over the inputs to decision-making can even help to preserve reputations when mistakes are made. Some central banks have already crossed the Rubicon on this issue. If you can publish an estimate of the “output gap” between the levels of demand and unobservable supply, then you can publish an estimate of the neutral rate too.

There is a reasonable concern about the spurious accuracy of point estimates but communicating the uncertainty around any estimate would be pretty straightforward too. Each policymaker could suggest an estimate of the location of neutral and their uncertainty around that number, which could be aggregated into a coherent joint communication on the subject.

Refusal to publish an estimate of neutral could start to compromise the communication of policy. As interest rates continue to fall it will become harder to claim that policy rates are still above neutral if policymakers remain silent on the location of the latter. Policymakers may feel they have to stop talking about whether policy is restrictive or not, which would be a retrograde step.

In any case, there is a compelling argument to publish just on transparency grounds. The norm is to disclose all the key judgments that inform the policy decision and that clearly includes the location of neutral. An increasing number of central banks are publishing views on the location of neutral. The sky has not fallen. 

The ultimate new year’s resolution would be to publish the likely path of the policy rate back to neutral. A good place to start is with an estimate of where interest rates are likely to settle in the medium run.