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First Impressions Matter

Janet Yellen has taken the helm of the United States Federal Reserve at an interesting time

The US economy is improving, and there is a belief that over the coming year the Fed will reduce the extent of the monetary stimulus that it is providing. Given the importance of managing expectations for central banks, the appointment of a new Chairperson or Governor is often a particularly significant period for anchoring inflation expectations. Since the preferences of the incoming banker are not known, much speculation surfaces regarding his or her perceived policy stance and its impact on expectations. For example, the day after the announcement that Mark Carney would become the next Bank of England Governor, The Wall Street Journal noted that the world’s financial analysts had turned into “ornithologists,” trying to determine whether in the balancing act between stabilising inflation and maximising employment, the new governor would prove to be a “hawk”, (more concerned about inflation) or a “dove”, (more concerned about employment). The same “hawk” and “dove” speculation is now beginning over Nemat Shafik and Andy Haldane, the two new members recently named to the Bank of England’s Monetary Policy Committee.

New members of independent monetary policy-making bodies signal their toughness on inflation by acting like hawks when they begin the job, but their dovish side comes out with more experience.

My recent research with Stephen Hansen sheds light on how monetary policymakers use signalling as a means of establishing their reputations and the effect this practice has on decision making. In our research, we devised new theoretical models for understanding reputational pressures on policy decisions, and then we compared the models’ predictions with empirical data from the Bank of England’s Monetary Policy Committee. Thus, our work represents the first empirical validation of monetary policy signalling models, and it provides a barometer of the accuracy of prevailing views about the ways in which bankers might try to strategically affect inflation expectations at the beginning of their tenures.

The prevailing view is that new bankers initially take a tougher stance against inflation than their preferences alone would dictate in order to convince the public they are serious inflation fighters. After this period of initial toughness, they ease back into a policy in line with their underlying preferences. The conventional wisdom and assumptions underlying much of the academic literature have been that only dovish monetary policy makers are the ones subject to incentives to signal toughness on inflation. In some cases, this is seen as leading to a detrimental outcome. The successor to Federal Reserve Chairman Ben Bernanke “will need to reassure the markets that he or she is tough enough to raise interest rates when necessary,” The Financial Times columnist Edward Luce wrote last year in discussing a potential downside of (the then unannounced) appointment of Janet Yellen. “Much as a dovish president might feel under pressure to order air strikes, Ms Yellen’s reputation could push her to tighten too soon. Such are the perverse incentives of expectations.”

“ Signalling increases the probability that new members will vote for high interest rates by up to 35 percentage points. ”

Our research shows that reputation is indeed a powerful force affecting members’ decisions. All bankers are tougher on inflation policy initially, but they tend to become less so with experience. While this evolution is more pronounced for doves than for hawks, all policymakers will be affected by such reputational concerns in some way. The policy effects of this pattern are measurable. Signalling increases the probability that new members are up to 35 percentage points more likely to choose high rates than experienced members, depending on how much uncertainty surrounds inflationary conditions at the time.

Given the expansion of central bank balance sheets through unconventional monetary policy, having a reputation for being tough on inflation is arguably even more important nowadays; to expand money supply and liquidity without de-anchoring inflation expectations requires a great deal of credibility. This issue was underscored in 2011 when Mario Draghi’s anticipated appointment as president of the European Central Bank gave rise to speculation that because he is Italian, he might have to go out of his way to rebut national stereotypes by being especially tough on inflation, with less expansionary unconventional policies immediately following his appointment. As Stephanie Flanders, then BBC economics editor, observed, “If you’re sitting in Spain and Portugal, you might well wonder whether you would have been better off with a German in charge, trying to show off his inner Italian – than an Italian desperate to prove he’s German underneath.”

Since the emergence of a consensus in the 1990s that independent central banks should set policy to establish credibility, there has been in our view a tendency to downplay the relevance of reputation. Our work shows that one should take seriously the idea that independent monetary policymakers care about their reputation for hawkishness. Reputation is important for understanding their behaviour, and understanding this behaviour of independent experts opens the door to new thinking about the optimal ways to design these important committees. For example, a preliminary conclusion is that there is a trade-off between rotating members relatively frequently (which maintains uncertainty on preferences and, so, too, the strength of the signalling incentive) and benefits of experience (which our estimates for hawkish members show might be important in some cases.)

“ Understanding the role reputation plays opens the door to new ways of thinking about optimal ways to design these important monetary policy committees. ”

In terms of the contemporary policy debate, our results are useful for clarifying how one should expect policy makers to behave. Consider again the suggestion that a hawkish German central banker would have come to the ECB job wishing to show off his inner dove, and that this behaviour may have been more desirable than a dovish Italian (Draghi) coming in trying to show off his toughness on inflation. Our analysis suggests that while it is true that Draghi would likely wish to signal his toughness on inflation, it is unlikely he would be more hawkish than an inherent hawk as the hawk would also wish to indicate her toughness on inflation. That is, so long as both members are concerned about keeping inflation expectations contained, both types will enter the job and adopt a more hawkish bias than their later selves. While the dove might initially be further from the voting rule he would use without signalling, it is worth remembering that the inherent differences between the types mean that the hawk will be tougher on inflation than the dove. This is where the conventional wisdom of assuming only doves are subject to reputational concerns appears to have been wrong.

Returning to the predictions on the behaviour of new policy makers, if we interpret Janet Yellen as an inherent dove, it is indeed true that she will be particularly keen to signal hawkishness to the market. But three caveats are in order.

First, all policy makers will engage in this behaviour to some extent, not just doves. And the result that doves signal more does not overturn the innate preference differences which mean that doves will always be less tough on inflation than hawks in both time periods.

Second, our analysis assumes that new policymakers have little existing reputation for setting monetary policy. In the case of Janet Yellen, this is not the case. She served as a Fed Governor and Vice-Chair of the Fed System from 2010 until her appointment as Chair; she was President of the San Francisco Fed from 2004-2010; and before that, from 1994 to1997, she had an earlier stint as a Fed Governor. If a new appointee already has a clearly established reputation, then there is less incentive for them to signal; their early actions affect public expectations much less when the public already has a strong belief about whether they are a hawk or a dove.

Third, it is not clear that Janet Yellen is a dove! While her more recent behaviour seems to be viewed as very dovish, in her earlier stints on the Federal Open Market Committee she was actually much more hawkish. In our model, all policymakers are trying to get the decision right and this will mean that they sometimes favour interest rates which are seen as hawkish and other times will take a more dovish position. So perceptions of Janet as a dove are probably wide of the mark; in our framework she would simply appear to be an expert who changes their stance appropriately as economic conditions necessitate.

Overall, Janet Yellen takes over the Fed at a time when the balance of risks is much less to the downside compared to even a year ago. She will need to carefully maintain a fine balance between being too hawkish too soon and too dovish for too long. The fact that her every move and speech will be carefully examined and assessed to ascertain if she is a hawk or a dove simply adds to high stakes nature of early months as the most important economist in the world.

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