behind-the-scenes-of-a-monetary-policy-decision

Behind The Scenes Of A Monetary Policy Decision

In this article we will take a closer look at the inner workings of a central bank board meeting. This will help you to understand how most banks determine monetary policy.

Most major central banks are structured in a similar manner. We will also be looking at why and how this helps each bank to make good policy decisions.

This will increase your understanding of how central banks operate behind the scenes. We will be looking closely into the following points:

  • Why Central Banks Meet As A Group
  • First Stage – Acquiring Information
  • Second Stage – Sharing information
  • Third Stage – Making A Policy Decision
  • Central Bank Case Studies

As a currency trader one of your primary jobs is to follow and track what each major central banks is doing.

The actions of each bank impact the direction of the related currency prices. Being able to predict currency price movements is central to whether you will make money or not.

According to the IMF, central banks began as dictatorial structures. The sole decision maker is often called the governor.

Over time they evolved to make their decisions via majority committee vote. This has made most major banks more democratic in nature.

Today, the governor is the symbolic head with several board members around them. All members vote and the majority wins the decision.

We are going to explore why these structures became common. We will also learn how they function so well.

It is interesting to note how and why the central banking systems have developed over the years.

Why Central Banks Meet As A Group

An economy is very difficult to gauge in the short term. Certain events and their future impact only become clear in hindsight.

The centre for central banking studies exists to help banks be more efficient. There is also the central bank research association.

They carry out research and conduct studies to help them offer the best advice to our central banks.

These studies highlight specific decision making structures. Most of the world’s central banks put in place these structures.

This helps each bank to operate in a manner that produces optimal policy decisions.

One of the most popular concepts used is that of group meetings. This is where several people physically meet to discuss the available information.

Central banks began as institutions directed by a single person.

No individual can have all information or interpret the information consistently. Relying on one person will lead to policy mistakes over time.

There are four reasons why meeting as a group is the best method for central bank meetings.

Firstly, the group can gather more information than any single individual. Better information leads to better decisions.

Secondly, even with the exact same information different individuals reach different conclusions. This varied analysis ensures that all relevant and beneficial information is extracted.

Errors or mistakes in the information can be quickly highlighted which reduces uncertainty. Finally, a committee eliminates the risk of extreme individual bias.

Central bank committees also use a similar process for making policy decisions.

It’s a process of three stages. Acquiring information, sharing information and decision making.

forex-source-infographic-21-06

Stage 1 – Acquiring Information

Board members track economic data through the acquisition of information. This gives them a feel for how the economy is performing.

According to marketrealist.com there are four things that the banks watch. These are the housing market, economic growth, inflation and the labour market.

Having a committee allows members to check the same data and reach their own conclusion

It’s more likely that all information comes to light if many people are researching it. This has obvious benefits to the ultimate decision.

The potential downside is that each person exerts less effort. They may do this because they know others are doing the same research.

Many studies have been conducted across a range of disciplines. They find shirking responsibility increases with the size of the decision making group.

This is why the minutes of each central bank meeting are made publicly available. It is clear which members have contributed the most to the information exchange.

This keeps each member accountable and working hard to gather the necessary information. Central banks publish the meeting minutes after each session.

Creating committees of optimal size is another method of avoiding this issue. In 2006, the economist Anne Sibert conducted a research study.

She concluded that the optimal committee size should be around 5-7 members. This ensures that everyone contributes equally to the decision.

Central banks use a rotational system when their board is greater than seven members. This limits the amount of people contributing to any single meeting.

Limiting committee size and making the contribution of each member public are effective. This reduces this tendency to free ride or shirk responsibility.

Stage 2 – Sharing information

When the central bank board meet they need to share information with each other. This is key to making sure the group makes a well informed decision.

A university of Kent study showed that human judgement is imperfect. The decision making process of an individual prone to bias and external influence.

This can be a problem for central bank committees. The quest for consensus can often lead to them missing out on effective alternatives.

This can lead to a policy committee failing to correct past mistakes when required.

This occurs when the group insulates itself from external views. It also happens when the leaders of the group promote a specific course of action.

This phenomenon is known as groupthink. Encouraging independence of each member counteracts the effects of groupthink.

A group made up of people from different backgrounds encourages independence.

Another issue for central bank boards is that of information cascading. This is when people are influenced by the decisions of others.

This occurs when a senior figure in a meeting proposes an idea. If the next person supports the idea it becomes harder for anyone to resist it.

This causes people that might feel inclined to disagree to go along with it anyway.

This subconscious bias makes it detrimental to a committee decision making process.

The way that banks reduce this is by having a different person begin the meeting each time. This stops any single person’s opinion having a disproportional influence.

Stage 3 – Making A Policy Decision

When the time comes to vote and make a decision there are other factors that can hinder a group. The main issue for central banks is the style of decision making that they use.

The two main concepts are voting and consensus. A vote simply attempts to reach a majority verdict. Consensus requires all members to be in support of the final decision.

With a vote, most of the members can support and pass a notion while a minority totally disagree.

This is avoided by a consensus mechanism which seeks to adjust and compromise the decision until everyone can support it.

The Hungarian national bank produced a report. It outlined the ideal structure for a central bank committee.

It states that the board must have a clear aim and full independence. This includes having at its disposal efficient monetary policy instruments.

The size of the committee must be no larger than five members. Voting rotation should be employed if there are more than five members.

There should also be measures in place to reduce free riding by individual members. This is achieved by publishing the contribution of each member.

Finally, there should be measures in place to reduce polarisation and groupthink. This involves building a competent group with some specific features.

Each member should be encouraged to think for themselves. The group must come from different backgrounds. They must also include a mix of internal and external members.

Having no fixed speaking order at each meeting avoids information cascades forming. Most central banks adhere to these processes in their own way.

To get a clear idea on how this operates in the real world we will look closely at some specific central banks.

Central Bank Case Studies

According to the above report the Bank of England follows this best practice guidance most effectively.

With diverse board members, this central bank has clear aims. These include academics, business representatives and central bankers.

They publish their minutes to display the contribution of its individual members. Interestingly, the governor has been on the losing side of a vote.

This shows that no single person has too much authority over the group.

The bank of Japan is also a highly effective group. They change the order of their meeting each time and have 9 members which is close to optimal.

Any member can propose interest rate adjustments. This which shows that they are open and unbiased.

The one downside to the BoJ is that they are staffed only by central bankers. This can increase the chances of groupthink.

The FOMC in the US and the ECB in the EU are very similar in their weaknesses as decision making structures.

They do not make individual contributions accessible. Both have committees that are too large. The head of both boards is also influential on the other members and the policy decisions in general.

They do include a wide array of information sources and inputs from different people. This is a positive aspect for the banks.

The bank of Canada has a clear objective and the size of its board is optimal. There is no mechanism in place to reveal the contributions of individual members.

The Swiss national bank has an interesting system for briefing its members. Each one is given information from different departments.

They keep the same speaking order for all meetings. This increases the chances of biases being promoted.

Despite differences most banks follow a similar structure.

Summary

In this article we have looked at why central banks structure themselves as groups. This avoids some common issues associated with single decision makers.

Groups have issues such as information cascading and individual free riding. Most banks install systems to reduce the impact of these things.

Each bank will work through a three stage process to make a policy decision. These are, information acquisition, discussion of information and the actual decision making process.

Human psychology plays a large part in how banks operate. Many studies attempt to find the most efficient way.

If you have any questions or comments on this article please leave them below. We read each one and try and reply to as many as we can.

We also use your feedback to create new articles and content in the future!

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