Woodford, Hall and the power of words - Julian Ashwin

In the 1986 World Cup, Diego Maradona scored twice against England. You probably remember the first goal, the "hand of God". But in a 2005 lecture, then Bank of England Governor Mervyn King argued that the second goal held a lesson for economic policy. Maradona ran more than half the pitch almost in a straight line the whole way, beating five players in the process. ¹ He could do this because the English defenders reacted to where they expected him to go, not to where he actually went. King called this the "Maradona theory of interest rates": central banks can steer the economy without moving interest rates very much, because people react to what they expect the central bank to do.

This year's Nobel Prize, awarded to Michael Woodford and Robert Hall, recognises key contributions to the economics behind this idea. Hall showed that households who plan ahead change their spending only when there is news about the future. His work became a building block of modern macroeconomic models, in which what people spend today depends not just on today's interest rate, but on where they expect rates to go. Woodford developed the modelling framework that puts expectations at the centre of monetary policy. As he put it, "not only do expectations about policy matter, but … very little else matters." If so, what a central bank says is as important as what it does. Speaking after the announcement, Woodford said policy should not just be about "pulling levers", but about talking to the public. This message has been hugely influential and has been taken very seriously by academics, policymakers and financial markets. In my career I have been influenced by these ideas in all three contexts. 

Academics

For academics, central bank communication has become a research field in its own right. Studies have shown that central bank statements move financial markets even when interest rates do not change, and that for longer-term interest rates the words can matter more than the decisions. This is particularly important in contexts where interest rates are already very low and so cannot be cut further, as was the case in Europe for much of the 2010s. Others have asked whether ordinary households are listening at all (often, they are not). Text analysis and machine learning now make it possible to measure what central bankers say at scale, something I have worked on myself, for example asking what the Federal Reserve chooses to talk about, and why. In other work, with Paul Beaudry and Martin Ellison, we used neural networks to study how people form expectations when interest rates cannot be cut any further. We find that these expectations can lead to the economy getting stuck for long periods with inflation well below target.

Policymakers

Central bankers have changed even more. For much of the twentieth century, central banking was closer to Maradona's first goal than his second, what King called the "mystery and mystique" approach. The US Federal Reserve did not even announce its interest rate decisions until 1994. Today, central banks publish forecasts and minutes, hold press conferences, and give "forward guidance" about future rates. Ben Bernanke once remarked that monetary policy is "98 percent talk and only two percent action". The most famous example is Mario Draghi's 2012 promise to do "whatever it takes" to save the euro. The bond-buying programme that followed was never actually used: the words alone were enough. When I was at the European Central Bank, one of the things I worked on was how the ECB communicates about the economic outlook, and I saw first hand how much care goes into choosing every word.

Markets

Financial markets have taken Woodford and Hall’s ideas to heart and watch central banks’ communication very carefully. Every statement is read closely for small shifts in tone, because a single word can move markets. This is taken very seriously and a lot of resources are devoted to it. For example, during my PhD, Goldman Sachs paid me (rather well) to build an algorithm that reads central bank statements and classifies them as "hawkish" or "dovish". The results showed that the tone of these statements contained information that could be used to make money.²

Of course, King also warned that Maradona could not score in every game by running in a straight line. Words only work if they are backed up by action when necessary. When inflation surged in 2021, assurances that it would be "transitory" turned out to be wrong, and central banks had to raise rates sharply. There are also those, such as the current chair of the Federal Reserve, who opposes forward guidance and argues that central banks now talk too much rather than focussing on delivering. So, as always, economics evolves and develops in response to the challenges of the time, but Woodford and Hall’s contributions endure.

^1. In their infinite wisdom, Fifa have described it as the Goal of the Century.

^2. Unfortunately, the details are proprietary, so you will have to take my word for it…