FRBSF Economic Letter
2007-12; May 25, 2007
Monetary Policy, Transparency, and Credibility: Conference Summary
This Economic Letter summarizes the papers
presented at a conference on "Monetary Policy, Transparency, and
Credibility" held at the Federal Reserve Bank of San
Francisco on March 23 and 24, 2007. The papers are listed
at the end and are available online.
At this year's conference, academic researchers and policymakers
gathered to discuss six research papers that focused
on transparency and credibility and how central banks can
achieve their goals by effectively communicating their
views on monetary policy as well as their views on the
economy, which inherently involve some degree of uncertainty.
Three of the papers focus on the benefits and limits
of transparency, identifying circumstances where transparency
may be helpful and those where it may be harmful. Another
paper studies central bank communication in an environment
where private agents have incomplete knowledge of the
economy.
A fifth paper analyzes policymaking in an economy whose
parameters are uncertain. A final paper examines the
role of the banking sector in the conduct of monetary policy.
The limits of transparency
It is increasingly common for central banks to be transparent
about their long-run inflation goals. In addition to
democratic accountability, underlying this transparency
is the hope
that by publicly announcing a target for inflation the
central bank will establish more quickly a reputation
for price stability and that this reputation will provide
a
firmer anchor for inflation expectations. By being more
open about its goals, procedures, and forecasts, the
central bank hopes to convince households and firms that
it is
committed to price stability, making inflation stabilization
less costly. However, even central banks admired for
their transparency are not necessarily all that transparent,
invariably withholding key information about their policy
objectives and their assessment of the economy and its
future prospects.
Although transparency is generally thought to be a good
thing, Cukierman examines the limits of monetary policy
transparency, focusing on two main dimensions: feasibility
and desirability. With respect to feasibility, Cukierman
argues that uncertainty about the economy, about the
effects monetary policy has on the economy, and about the
measurement
of key variables like potential output, the output gap,
and the natural rate of unemployment make it extremely
difficult for even well-intentioned central banks to
be fully transparent. In Cukierman's words, "the 'science
of monetary policy' is not yet in a stage at which it can
replace the 'art of monetary policy'" (p. 32). With
respect to desirability, Cukierman argues that a compelling
case for secrecy can be made when the central bank has
private information about threats to financial stability,
such as about the health of banks. There, too much disclosure
may lead to contagion, jeopardizing the wider banking system.
Monetary policy and its informative value
It is sometimes argued that households and firms may
place too much weight on the central bank's assessment
of the
economy, which can be problematic when the central bank's
information about the economy is imprecise. If its views
about the economy are overly influential, then it may
be optimal for a central bank to not reveal its views,
to
not be transparent. However, because central banks base
their policy decisions on their assessment of the economy,
policy interventions intended to stabilize the economy
cannot help but convey information about the economy,
even if the interventions are not accompanied by formal
policy
statements. Of course, it is generally not possible for
private agents to infer unambiguously the central bank's
information about the economy simply by observing the
policy interest rate, but the fact remains that the very
act of
conducting stabilization policy inevitably reveals information.
Recognizing that the policy interest rate has a stabilization
role and an information role, Baeriswyl and Cornand analyze
jointly the optimal monetary policy and the
optimal level of transparency. In their framework, the central bank conducts
monetary policy to stabilize prices and output, but an opaque central bank
does not divulge its information about the economy while
a fully transparent central
bank does. Employing a small-scale model in which fluctuations are caused by
demand and supply shocks, Baeriswyl and Cornand show that greater transparency
is desirable when supply shocks are not too volatile, when the central bank
is more focused on stabilizing prices than output, and
when firms already have relatively
precise information about the economy
Three great American disinflations
Although there is little doubt that episodes of deflation
or disinflation can be costly for the real economy, there
is less agreement about the factors that
contribute to the high real cost or about why the real cost varies across episodes.
Naturally, disagreement about the factors that influence the real cost of deflation
(or disinflation) stimulates debate about how inflation might best be lowered.
For example, during the 1970s and 1980s some argued that inflation should be
lowered gradually while others argued for an aggressive monetary tightening
intended to lower inflation sharply.
To uncover the factors that govern the costs associated
with deflation or disinflation, Bordo, Erceg, Levin, and
Michaels analyze three episodes of deliberate monetary
contraction: the 1870s post-Civil War deflation; the 1920-1921 post-WWI deflation;
and the early 1980s disinflation under Federal Reserve Chairman Volcker. In
the case of the 1870s deflation, the authors argue that
the highly transparent policy
objective coupled with a credible commitment allowed a decline in the price
level to occur alongside robust real output growth. In
contrast, the abrupt shift to
a contractionary policy stance in 1920 produced a rapid decline in prices,
but at the cost of a sharp fall in output. Here, the authors
argue, deflation came
at a higher cost because the Federal Reserve departed sharply from the expansionary
policy that it had pursued previously. For the Volcker disinflation, the authors
argue that a lack of policy credibility, brought about by the rise in inflation
that occurred during the late 1960s and 1970s, contributed importantly to the
large real cost associated with inflation's decline.
Central bank communication
Since the early 1990s, central banks have increasingly
adopted inflation targeting as a framework for conducting
monetary policy. A cornerstone of inflation targeting
is a publicly announced numerical value, or range, for some measure of inflation.
Some, but not all, inflation targeting central banks also make public the forecasts,
or projections, upon which their policy decisions are based. The underlying
rationale is that central banks can more firmly anchor
inflation expectations if they provide
private agents with guidance about monetary policy, and by anchoring inflation
expectations firmly, the central bank can help prevent undesired fluctuations
in the economy and mitigate the possibility of economic instability. But is
announcing an inflation target sufficient to anchor inflation
expectations, or does the
central bank also need to articulate, in some form or other, how the inflation
target is to be achieved? Does the central bank need to reveal any trade-offs
it perceives in meeting the inflation objective against other policy objectives?
Eusepi and Preston study these issues using a model in
which households and firms have incomplete knowledge of
the economy and must learn about monetary policy
before they can make decisions. In their framework, central bank communication
involves revealing to private agents information that they can use to help
learn and forecast the economy. They begin by showing that
self-fulfilling expectations
often arise if the central bank does not communicate with private agents. Alternatively,
by communicating the entire policy decision process--which in this model is
the coefficients and variables that enter the policy rule--the
optimal policy is
successfully implemented and instability is mitigated. For intermediate cases,
the authors find that communicating to private agents the inflation target
and the variables that enter the central bank's policy
rule garners the same benefits
as communicating the entire policy process. However, in a key result, the authors
demonstrate that communicating the inflation target only is insufficient to
anchor inflation expectations.
Monetary policy and uncertainty
An issue that central banks are increasingly grappling
with is how to best formulate policy when there is uncertainty
about the economy. One reason that uncertainty
about the economy, especially uncertainty about the parameters that govern
the policy transmission mechanism, is troublesome for central
banks is that it raises
doubts about the timing and magnitude with which policy actions affect the
economy. Another subtle, and less widely recognized, reason
that parameter uncertainty
is troublesome is that it can render uncertain the very goals and objectives
to which monetary policy should be directed. Taking the position that monetary
policy should attempt to maximize the welfare of a stand-in representative
household, Edge, Laubach, and Williams argue that uncertainty
about the parameters that
govern the household's preferences and the economy's production technology
will affect the economy's dynamic behavior, key variables
like the output gap and
natural rate of interest, and the policy objective function.
To understand the impact of parameter uncertainty on
policy design, Edge, Laubach, and Williams study a simulated
economy in which parameter uncertainty has the
three effects described above. They show that parameter uncertainty leads to
the economy's potential output and natural rate of interest being imprecisely
estimated. Imprecision about the natural rate of interest makes it difficult
for the central bank to determine the appropriate level of interest rates,
while imprecision about potential output makes it harder
for the central bank to assess
whether the economy's productive resources are under- or overutilized. In terms
of optimal policymaking, they show that parameter uncertainty means that policymakers
should rely less on estimates of the output gap and more on variables like
prices and wages that can be measured with greater precision.
Banking and interest rates in monetary policy analysis
Modern studies examining the design and conduct of monetary
policy generally employ models, or frameworks, in which
a significant role for monetary aggregates
and financial intermediation is absent. Instead, monetary policy is invariably
analyzed in terms of how to set a short-term nominal interest rate, with the
central bank then supplying the quantity of money required to satisfy demand.
Moreover, the banking section is invariably taken to be perfectly competitive
or simply omitted, such that the economy effectively contains a single short-term
nominal interest rate. Although this approach to modeling monetary policy is
widely accepted among central banks and academia, it may prove misleading if
factors such as collateral, financial intermediation, or a need by banks to
monitor loans give rise to an array of interest rates with
differing effects on the economy.
To assess whether such factors may be important, Goodfriend
and McCallum develop a model suitable for policy analysis
that contains a banking sector in addition
to the usual goods-producing sector. In the banking sector, loan production
requires both collateral (with capital less useful than
bonds as collateral) and loan-monitoring
inputs, giving rise to an endogenous external finance premium. Accordingly,
a monetary policy that stimulates economic activity may
either raise or lower the
external finance premium, depending on model parameters. By raising the value
of collateral, the stimulus may lower the external finance premium, generating
a "banking accelerator" or, by raising the demand for bank deposits,
the stimulus may raise the external finance premium, generating a "banking
attenuator." With the rates of return on government bonds, deposits, collateralized
loans, and uncollateralized loans varying from each other and from the return
on physical capital, the key result in the paper is to show that in response
to a shock to goods-sector productivity a monetary policy that ignores the distinction
between these various rates of return could go terribly awry. Richard Dennis
Senior Economist
John C. Williams
Senior Vice President and Advisor
References
[URLs accessed April 2007.]
Baeriswyl, Romain, and Camille Cornand. 2007. “Monetary
Policy and Its Informative Value.” London School
of Economics Financial Markets Group Discussion Paper #569.
(PDF - 251KB)
Bordo, Michael, Christopher Erceg, Andrew Levin, and
Ryan Michaels. 2007. “Three
Great American Inflations.” National
Bureau of Economic Research Working Paper #12982. (PDF
- 263KB)
Cukierman, Alex. 2007. “The
Limits of Transparency.” Manuscript. (PDF -
313KB)
Edge, Rochelle, Thomas Laubach, and John Williams. 2007. “Welfare-Maximizing
Monetary Policy under Parameter Uncertainty.” Federal
Reserve Bank of San Francisco, manuscript. (PDF -
265KB)
Eusepi, Stefano, and Bruce Preston. 2007. “Central
Bank Communication and Expectations Stabilization.” Federal
Reserve Bank of New York Staff Report #199 (PDF -
268KB)
Goodfriend, Marvin, and Bennett
McCallum. 2007. “Banking
and Interest Rates in Monetary Policy Analysis: A
Quantitative Exploration.” Manuscript. (PDF -
728KB)
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