Outcome: August 2011

PRO-POL: Probabilistic interest rate setting project

Monetary policymaking is imperfect. When a central bank sets the appropriate target cash rate each month, there is considerable approximation implied. The imprecision stems from the uncertainties in real-time measurements, latent variables, the type of model, model parameters and the inherently unpredictable nature of the macroeconomy. Whatever rate the central bank sets, there is considerable probability that a different rate would be more appropriate.

Nevertheless, most central banks provide little quantifiable information on the uncertainty confronting policymakers. Conventional central bank communication of interest rate setting does not formalize risk considerations, and the probability of extreme events. The probability that the interest rate should be substantially different from the "most preferred" target rate receives little attention. Central banks currently record formally neither the uncertainty experienced by individual board members, nor by the board as a whole.

The aim of this project is to resolve two outstanding issues:

1. Can an individual monetary policy decision-maker quantify her (his) uncertainty about the appropriate target cash rate?
2. Can the risks envisaged by individual decision-makers be aggregated to give a collective view about the appropriate cash rate?

We emphasize that this project is not aimed at the prediction of RBA Board behaviour. In common with shadowing exercises in other countries (eg the US Shadow Open Market Committee), this is a normative exercise in control, not forecasting.

The shadow board has been running as a trial since August 2011, and a distinguished team of macroeconomists has been assembled to participate in the study as shadow board members).

Each member of the shadow board records the uncertainty by giving probabilistic assessments of the appropriate (target) interest rate for each round. These outcomes are published on the website on the Monday before the RBA board decision.