Market participants – and indeed the general public – will learn about the authorities’ behaviour and shape their own  10  For more information, see “The Corporate Sector and the Bank of England’s Asset Purchases” available at: http://www.bankofengland.co.uk/publications/Pages/speeches/2010/423.aspx  BIS central bankers’ speeches  5  accordingly. Moral hazard is one aspect of this – that can lead to market participants taking more risky actions because of the perceived backstop provided by the central bank. More generally, communications strategies can be a positive part of the toolkit, in particular by giving out information about the central bank’s monetary policy “reaction function”. For the most part it is helpful for markets to be able to predict what the central bank will do. That way one can often hope to generate the desired responses with less severe policy actions than otherwise. Credibility matters. For example, if people believe that inflation will be 2% in the medium term, and act accordingly, it is much more likely that inflation will stay close to 2% in practice without big swings in monetary policy. Keeping inflation under control is much more costly for the economy if expectations become de-anchored from the official target. But how explicit do we need to be about our forward plans? This is a very live policy debate.
The recovery in financial markets that we have seen in the past 6 months or so, is in part driven by the statement that the ECB will do “whatever it takes” to keep the euro area together and the perceived commitment that the Fed will do whatever it takes to restore growth in the US. The belief in these policy approaches has been immensely powerful. But it must be backed not only by perceived intent but also by capability and delivery if needed – and economies always generate some surprises. If the actions don’t follow the words when necessary, then similar policy statements in future will be less effective. In the UK, market expectations are already consistent with monetary policy remaining very supportive for some time to come, indicating no change in Bank Rate until well into 2015. Yet there is still a debate about whether the MPC should give more “forward guidance”. In practice we have being doing this through the Inflation Report. The most recent edition makes it clear that we do not see much pressure arising from domestically generated inflation. Rather, we continue to see inflation being driven by factors such as tax changes, higher commodity and energy prices, and other external influences. These and similar adverse relative price changes have made us all financially worse off and contributed to keeping inflation higher than target over the past few years. In response, the Bank could have chosen to tighten monetary policy to keep measured inflation rates down.