Economic Letter 2001-26; September 7,
Transparency in Monetary Policy
The title of a popular 1987 book by William Greider on the Federal Reserve
said it all: Secrets of the Temple conjured up an image of the
high priests of monetary policy hidden away behind marble walls in Washington,
D. C., making mysterious decisions that affected the lives of all Americans.
While the Fed's policymaking body, the Federal Open Market Committee (FOMC),
would eventually release minutes of its meetings, and the Chairman did
testify twice a year before Congress and would frequently give public
speeches, that image of secrecy was one that central bankers often seemed
to enjoy cultivating. At the time Greider wrote his book, the FOMC rarely
provided timely public statements to explain why a policy action was taken.
And the testimony of Federal Reserve Chairmen before Congressional committees
was seldom designed for maximum clarity. In fact, Newsweek reported
this quote from Alan Greenspan: "Since I have become a central banker,
I have learned to mumble with great coherence" (July 25, 1988, p. 54).
Today, FOMC policy decisions are much more transparent. Immediately
after each meeting, the FOMC issues a press release that explains any
monetary policy action taken during the meeting. The FOMC also gives some
indication of its future policy concerns and intentions. For example,
after its June 27, 2001 meeting, at which the FOMC approved a 25-basis-point
cut in its federal funds rate target to 3-3/4 percent, its press release
Although continuing favorable trends bolster long-term prospects for
productivity growth and the economy, the Committee continues to believe
that against the background of its long-run goals of price stability and
sustainable economic growth and of the information currently available,
the risks are weighted mainly toward conditions that may generate economic
weakness in the foreseeable future.
Commentators quickly interpreted this as a signal that future rate cuts
might be in the offing.
The move towards greater transparency in monetary policy is not confined
to the United States. In fact, central banks in several other countries
have gone even further. This general trend reflects, in part, research
by academic economists that has stressed the potential benefits of making
monetary policy easier to understand. In this Letter, I review
the arguments for, and against, greater transparency. Economists have
identified some clear benefits, but there may be potential costs as well.
What does transparency mean?
One difficulty in evaluating the potential costs and benefits of transparency
is that the term has been used in several different ways. This is perhaps
natural since transparency becomes an issue only when there is a problem
of imperfect or incomplete information, and information can be imperfect
or incomplete in many different ways. To understand the various aspects
of policy transparency, it is helpful to focus on three key ingredients
in the formulation and implementation of monetary policy—the central
bank's objectives, the bank's assessment of the linkages between policy
actions and the economy (the bank's "model" of the economy), and the bank's
information about economic conditions. Each of these three factors—objectives,
model, and information—can cause monetary policy to be opaque.
Transparency about objectives
Perhaps the most common notion of transparency in the economics literature
is that associated with objectives. The public may be uncertain about
the true objectives of monetary policy, or, while understanding that the
central bank may desire low and stable inflation and full employment,
the public may find it difficult to know how the central bank would trade
off a bit more unemployment to gain lower inflation or how much increased
inflation it might accept to prevent unemployment from rising. A policy
is transparent about objectives if the public can accurately gauge the
central bank's intentions.
It is natural to think of transparency in terms of intentions if policy
objectives tend to shift over time. Faust and Svensson (2001) and Jensen
(2000) provide recent analyses of transparency when objectives may change.
When intentions are more transparent, the public is able to form more
accurate forecasts of future policy actions and economic developments.
The emphasis on intentions arises from the view that the central
bank's goals for employment or growth may be unrealistic or unsustainable,
or the central bank might be subject to "behind-the-scenes" political
pressures to expand employment. Over the past twenty years, a large literature
has analyzed the consequences for inflation when objectives for economic
growth are too ambitious or when central banks face political pressures.
In either case, the public will expect higher inflation. This boosts actual
inflation, and the central bank is forced to accept either higher inflation
or a slowdown and higher unemployment to bring inflation back down (for
a survey, see Walsh 1998, Ch. 8).
Faust and Svensson (2001) argue that greater policy transparency
is highly desirable because it leads to better economic outcomes. Transparency
does so mainly by minimizing the central bank's incentive to engage in
overly expansionary policies. If the central bank's objectives shift and
it attempts to pursue an overly expansionary policy, the public quickly
catches on when the policy framework is transparent. As a result, inflation
expectations rise sharply. Because it is costly for the central bank to
lower inflation expectations, the central bank is deterred from trying
such a policy.
Jensen (2000) argues, on the contrary, that there can be a cost to
greater transparency, particularly if the central bank already has a good
reputation for maintaining low inflation. Increased transparency about
any changes in the central bank's objectives will cause the public's inflation
expectations to become more variable, which would cause actual
inflation to become more variable. To reduce the undesirable variability
in actual inflation, the central bank must focus relatively more on stabilizing
inflation and less on stabilizing output and employment. This distorts
stabilization policies and may lead to worse economic outcomes.
Transparency about economic models
Even if the public clearly understands the central bank's objectives—perhaps
because they are formalized in the bank's charter, as is the case in New
Zealand and the European Monetary Union, or because the government has
publicly established policy objectives for the central bank, as is the
case in the United Kingdom—monetary policy may be opaque because the
public does not understand the economic model the central bank uses to
evaluate alternative policies.
This uncertainty can be qualitative—does the central bank view its
effects on the money supply, interest rates, or general credit conditions
as the chief link between its actions and economic activity? Or the uncertainty
can be quantitative—if the chief linkage involves interest rates, how
big a rate cut is needed to offset a projected one percentage point rise
in unemployment? In either case, the public may have difficulty knowing
whether the central bank is likely to change interest rates by 50 basis
points or by 150 basis points to achieve its objectives.
Alex Cukierman (2000) has emphasized that, in practice, even the most
transparent central banks have not been very transparent about the economic
model they use. He notes that central banks can hardly be blamed for this—academic
economists are themselves uncertain as to the true model of the economy.
As a consequence, central banks are typically forced to employ several
different economic models to evaluate policies. How these alternative
models are then synthesized into a specific policy recommendation is part
of the "art" of monetary policy (Walsh 2001) and may be difficult to convey
to the public.
Transparency about economic conditions
Even if objectives are clearly stated and the central bank's model is
well understood, the public may not have the same information on current
economic conditions that the central bank has. For example, in theory,
the central bank may have preliminary data on the economy before it is
widely available to the public. Thus, the central bank might cut interest
rates because new data suggest an economic slowdown. But if these data
are not publicly available, the public may be uncertain whether the rate
cut is designed to offset a likely recession or to expand the economy,
thereby risking an increase in inflation.
In this interpretation, a transparent policy regime is one in which the
public is provided with the same information on economic conditions as
is provided to the central bank. The argument for revealing all the information
that the central bank has about the economy stresses that this information
is critical for assessing how well the central bank is doing its job.
Central banks cannot control inflation perfectly, so holding them accountable
for achieving a specific target for the inflation rate is unrealistic.
If inflation rises above target, it is important to know whether this
was due to factors that the central bank could not have foreseen, or whether
the central bank should have been able to predict the rise and adjusted
policy to counteract it.
Transparency, in this view, is related to notions of accountability—if
the public knows what the central bank knows, then it can assess whether
the central bank made the right policy choices. The public needs good
information to assess whether the central bank did what it should have
done. If new information about the economy suggests that a rise in inflation
is likely, the public can assess whether interest rates should be raised
and, if so, by how much, and they can then judge whether the central bank
implemented the correct policy.
Transparency about information helps make central banks accountable,
but it may also come with a cost. Cukierman (2001) shows that inflationary
expectations are more variable if the public has better information about
current economic disturbances. As a consequence, interest rates become
more variable as well. If interest rate volatility is costly, as is sometimes
argued, then greater transparency is not a free lunch.
Transparency and inflation targeting
In recent years, several central banks have adopted inflation targeting
as a framework for conducting policy. Under an inflation targeting regime,
the central bank commits to achieving a target rate of inflation. This
target may be set by the government (as is the case in the United Kingdom),
or it may be set by the central bank itself (as is the case in Sweden).
Proponents of inflation targeting have stressed that it is a very transparent
means of implementing monetary policy. The inflation target is publicly
announced, so the objectives of the central bank are made transparent.
However, even inflation targeting may not lead to complete transparency.
Simply announcing a target for average inflation does not indicate how
the central bank will respond if a recession threatens or if energy prices
jump, and objectives are not the only aspects of policy that lead to uncertainty
Proponents of inflation targeting also call on central banks to issue
detailed reports on economic conditions and the outlook for inflation,
as the Bank of England does in its Inflation Reports (http://bankofengland.co.uk).
Such reports can go a long way towards giving the public better information
on monetary policy as well as some insight into the bank's forecasts of
future developments. These forecasts contribute to the overall transparency
of policy, even though they do not allow the public to identify either
the economic model or the information about economic conditions that were
combined to produce the bank's forecast.
The economics literature has identified the potential costs of greater
transparency about policy goals and intentions—an overemphasis on inflation
stabilization at the cost of employment fluctuations and excessive interest
rate volatility. As yet, however, there are no quantitative estimates
of either the gains or costs of transparency. Until there are, the general
principles that (a) policymakers should strive for clarity and that (b)
the public has a right to hold policymakers accountable suggest that recent
moves by the Federal Reserve and other central banks to make monetary
policy less opaque are positive developments.
Carl E. Walsh
Professor of Economics
University of California, Santa Cruz and
Federal Reserve Bank of San Francisco
Cukierman, Alex. Forthcoming 2001 "Accountability, Credibility, Transparency
and Stabilization Policies in the Eurosystem." In The EMU and its Impact
on Europe and the Developing Countries, ed. C. Wyplosz. Oxford: Oxford
Cukierman, Alex. 2000. "Are Contemporary Central Banks Transparent about
Economic Models and Objectives and What Difference Does it Make?" Presented
at the Bundesbank Conference on "Transparency in Monetary Policy" (October).
Faust, Jon, and Lars E. O. Svensson. 2001. "Transparency and Credibility:
Monetary Policy with Unobservable Goals." International Economic Review
Jensen, Henrik. 2000. "Optimal Degrees of Transparency in Monetary Policymaking."
University of Copenhagen (December).
Walsh ,Carl E. 1998. Monetary Theory and Policy. Cambridge, MA:
Walsh, Carl E. 2001. "The Science (and Art) of Monetary Policy." FRBSF
Economic Letter 2001-13 (May 4). http://www.frbsf.org/publications/economics/letter/2001/el2001-13.html