Dr. Econ

Why do Fed officials communicate with the nation so often?

June 2006

Now this is a very important question. The answer is related to the topic of Fed transparency, which is crucial to the effectiveness of monetary policy.

You are absolutely correct to have noticed that Fed officials speak to the public quite often, and have been doing so even more frequently in recent years. Members of the Federal Reserve Board of Governors generally give speeches several times a month. Presidents of the twelve regional Federal Reserve Banks also frequently speak to the public. Speeches given by officials from every Federal Reserve District can be found on the respective Federal Reserve Bank’s website, and are also linked to from the Minneapolis Fed’s website.

Benefits of transparency

Why do Fed officials communicate with the public so often? In short, the Fed, and in fact many central banks around the world, believe that frequent communication with the public makes the conduct of monetary policy more transparent to the public. There are several reasons why transparency is important:

  1. Being transparent can be viewed as the responsibility of central bankers because their decisions have such a strong impact on everyone in the economy. In words of then-Governor and now Chairman Ben Bernanke (2004), “[A]s public servants whose decisions affect the lives of every citizen, central bankers have a responsibility to provide the public as much explanation of those decisions as possible, so long as doing so does not compromise the decisionmaking process itself.”

  2. There is some evidence that the Fed may produce better forecasts of output and inflation than private sector forecasters and the general public (Romer and Romer, 2000). As a result, Fed communication with the public (through speeches, publications, and statements accompanying its policy actions) may help improve the public’s economic forecasts and their understanding of the current state of the economy.

  3. Transparency increases the near-term predictability of rate decisions made by the Federal Open Market Committee (FOMC), the Fed’s monetary policymaking body (Swanson 2004). This allows for smoother adjustment of the economy to monetary policy decisions about interest rates.

  4. Transparency can help anchor the public’s long-term expectations, especially inflation expectations, which itself is important for several reasons. As Federal Reserve Chairman Ben Bernanke points out in a 2004 speech, anchored expectations are thought to help reduce macroeconomic and financial market volatility. Contained inflation expectations also help keep actual inflation low by avoiding what economists sometimes refer to as a “wage-price spiral”, in which people bid up wages and raise prices to maintain their real incomes in anticipation of future higher prices. Additionally, contained inflation expectations allow the central bank more short-term flexibility to respond to output and employment shocks (because there is less risk that easing policy will generate public fears of inflation).

  5. Transparency gives policymakers an additional incentive to organize their thoughts on policy. In a 2001 address, Bill Poole, president of the Federal Reserve Bank of St. Louis, pointed out that,

    “An advantage of transparency in this sense, familiar to every teacher and researcher, is that the best way to be sure you understand an issue is to explain it to others, in a class, a journal article, a lecture, or in meeting minutes. Transparency is a great spur to developing coherent views, and surely it is beneficial to policymakers to be coherent in their own thinking.”

Possible costs of transparency

While some degree of central bank transparency is likely to convey benefits for the reasons discussed above, it may also have some costs that could limit the amount of transparency that is desirable in practice.

For example, in the words of economist Alex Cukierman (2007), one danger of transparency is that a central bank “may give the impression to the public that it knows more than it actually does.” It is important to realize that central banks operate in an uncertain environment in at least three different realms: uncertainty about the data, uncertainty about the nature and persistence of shocks to the economy, and uncertainty about the structure of the economy (Bean 2005). To be completely transparent the central bank would have to convey to the public not only the most likely path of key economic variables (such as GDP and inflation), “but also the uncertainty around that trajectory and perhaps some indication of how policy might react under the myriad ways that the uncertainty could be resolved” (Geithner 2006), which could be very difficult to communicate to the public in a clear and concise manner. For an extensive discussion on the uncertainty associated with monetary policy, see a December 2006 speech by Federal Reserve Board of Governors Vice Chairman Donald Kohn.

An additional challenge central banks face by being transparent is that monetary policy decisions typically are not made by one person using one precise economic model, but rather by a committee that by may be using and interpreting many different economic models, each of which has its own strengths and weaknesses – this fact often leads to descriptions of monetary policy as being both an art and a science. Because the economy is large and complicated, the perspectives and insights of many people with many different specialties (and many different economic models!) are required for policymaking, and that can make the task of synthesizing important points for clear and useful public communication more than a little bit challenging. It is conceivable that imprecise central bank communication, or communication that oversimplifies the diversity of views of individual committee members and their various economic models, could create more confusion than clarity.

Communicating the magnitude and sources of uncertainty and disagreement is an extremely challenging task, and much economic research is devoted to identifying the best ways for central banks to be transparent. Though the answers aren’t always clear, some people have attempted to lay out broad guidelines for how transparent central banks should be. For example, Lucas Papademos, vice president of the European Central Bank, which also places high importance on transparency, has advised that the “central bank should be as transparent as possible, but no more so than is realistically useful for enhancing the clarity and understanding of the future monetary policy stance” (Papademos 2006).

I mentioned above that transparency is viewed as highly important to many central banks around the world.1 See steps the Federal Reserve has taken to be more transparent in my September 2006 posting.


NOTE: For additional steps the Fed has taken towards transparency from 2006 to 2012:

Dr. Econ (2012:Q2): You have written about Fed transparency before, but I wonder if the Federal Reserve has learned any new lessons in the aftermath of the financial crisis?

John C. Williams. 2011. "Opening the Temple." Annual Report, Federal Reserve Bank of San Francisco.

References:

Bean, Charles. 2005. "Monetary Policy in an Uncertain World." Speech at Oxonia Distinguished Speakers Seminar, The Oxford Institute of Economic Policy, Oxford, February 22.

Bernanke, Ben S. 2004. “The Great Moderation.” Speech to the Eastern Economic Association, Washington D.C., February 20.

Bernanke, Ben S. 2004. “Central Bank Talk and Monetary Policy.” Speech to the Japan Society Corporate Luncheon, New York, N.Y., October 7.

Cukierman, Alex. 2005. “The Limits of Transparency”, unpublished manuscript, Tel Aviv University.

Geithner, Timothy. 2006. “Uncertainty and Transparency in the Conduct of Monetary Policy.” Remarks at Financial Services Leadership Forum Breakfast, New York, N.Y.

Kohn, Donald L. 2006. “Monetary Policy and Uncertainty.” Remarks at the Fourth Conference of the International Research Forum on Monetary Policy, Washington, D.C.

Papademos, Lucas. 2006. Intervention as panelist in Session 1 on Monetary Policy at a conference on “Central banks in the 21st century” organized by Banco de España, June.

Poole, William. 2001. “Central Bank Transparency: Why and How?” Remarks at the session on "How Transparent Should a Central Bank Be?" held at the Philadelphia Fed Policy Forum, Federal Reserve Bank of Philadelphia.

Romer, Christina D. and David H. Romer. 2000. “Federal Reserve Information and the Behavior of Interest Rates” American Economic Review, vol. 90 (June), pp. 429-57.

Swanson, Eric. 2004. "Federal Reserve Transparency and Financial Market Forecasts of Short-Term Interest Rates." Finance and Economics Discussion Paper No. 2004-6. Board of Governors of the Federal Reserve System.

Endnote

1. Some central banks have web pages devoted to explaining the importance they place on transparency. For example, see web pages of the Bank of Japan and the European Central Bank.