Introduction to Fan Charts
The South African Reserve Bank, like many other central banks, uses a "fan chart" to show the uncertainty of its predicted policy rate path. This chart is a way to communicate that future policy rate settings depend on unpredictable events that will happen in the future. The wider the range around a projection, the more uncertain the bank is about its forecasts.
Purpose of Fan Charts
By using forecast ranges instead of single-line forecasts, fan charts help to make policy decisions more transparent and accountable. They show that policymaking is based on judgments of the probabilities of specific outcomes and their drivers. This should help focus monetary policy discussions on a range of possible scenarios, rather than just one.
Current Limitations of the Reserve Bank’s Framework
The Reserve Bank’s framework is missing some elements to achieve its intentions. Specifically, the Bank does not clearly connect how it communicates its policy decisions with the projections it publishes. It also does not quantify how it weighs competing risks to its projections.
How the Reserve Bank Makes Decisions
The Reserve Bank sets its policy rate based on votes from its monetary policy committee (MPC) members. Each member has their own views on how the economy works and the balance of different risks that face the economy. The Bank’s projections and fan chart come from a model that does not take into account any risk assessment. This model assumes an economic narrative about the future that may differ from what MPC members have in mind when they vote.
Remedies for the Current Limitations
One solution would be for the Bank to formally explain how MPC members’ views about the outlook differ from what has been assumed in the Bank’s forecasts. Alternatively, the Bank could align its projections with the collective view of the MPC members, as is done by some leading central banks, such as the Bank of England.
Advances in Modelling
Advances in modelling have made it easier to present alternative macroeconomic scenarios and their drivers. They also allow for the quantification of the extent of uncertainty about projections. For example, one can estimate the risk balance for specific asset prices, such as the exchange rate or oil price, using market pricing. It is also possible to estimate the likelihood of specific outcomes from specific models or track the assumptions that have contributed to forecast errors.
The Need for Greater Transparency
The Reserve Bank has started publishing some information on the scenarios it considered when policy decisions were made. However, it does not consistently publish data on precisely what these scenarios involve or describe their underlying economic drivers. Without this information, it is difficult to understand whether the Bank’s various projections are economically coherent and useful for scenario planning by firms and market analysts.
Conclusion
The probability that any specific central bank scenario will occur exactly as published is effectively zero. These projections are useful as a benchmark for scenario analysis that helps communicate how the central bank would respond should specific shocks eventuate. It is time for the Reserve Bank to replace fan charts with forecast scenario driver analysis and detailed balance of risk assessments. This would promote a risk management approach to monetary policy and help the public better understand its policy settings. By doing so, the Bank can enhance the transparency and accountability of its decision-making process, ultimately contributing to more effective monetary policy.
