Michael Ehrmann*

 

 

“Since I have become a central banker I have learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.” Alan Greenspan, 1987

 

Some years later…

 

“Openness is more than just useful in shaping better economic performance. Openness is an obligation of a central bank in a free and democratic society.” Alan Greenspan, 2001

 

Central banks have the responsibility to maintain the stability of their currency. While this task has remained unchanged, the last two decades have seen major changes in the way central banks aim to achieve this goal. Central banks have undergone a long journey from secretive to transparent institutions; nowadays, they emphasise predictability of their actions as an important ingredient of their task, compared to a conducting of monetary policy that has often largely surprised the public in the not too distant past. As central banks were shrouded in mystery, books such as “Secrets of the Temple: How the Federal Reserve Runs the Country” made it to the bestseller lists in the 1980s.

 

What has brought about this remarkable development, and what are its effects? A major factor has been a radical change in the thinking of the economics profession in the 1970s: the role of expectations in economic behaviour gained widespread attention. This revolution has not left economic thinking about monetary policy unaffected. While it is widely recognised that monetary policy has no leverage over economic growth in the long run, it could possibly generate short-lived growth through unexpected expansions of the money supply. Central banks that are run by governments might therefore be tempted to exploit this opportunity, and boost economic activity, for instance in advance of an election. As this would come at the cost of higher inflation, the public would have no reason to trust that the central bank is focusing on its primary goal of maintaining the stability of the currency. Accordingly, the public will adjust inflation expectations upwards. This, in turn, is likely to have repercussions on the actual inflation outcome, e.g. through higher wage claims, and thus trigger a vicious circle of higher inflation expectations and higher inflation outcomes.

How can this incentive problem be addressed? The pioneering students of this problem, Finn E. Kydland and Edward C. Prescott, who were awarded the Nobel Prize in Economics in 2004 for their path-breaking research, emphasised that it is necessary to design mechanisms that tie the hands of the central bank. Central bank behaviour should be governed by rules rather than discretion. To make this sustainable, it is useful to grant them independence from the government. As a matter of fact, the number of independent central banks has increased sharply during recent decades. This raises an issue of accountability – being outside the democratic checks through the electoral system, other modes of making the institution accountable to the people need to be put in place. For that reason, testimonies to the respective parliaments have become common practice. At the same time, transparency, a necessary condition for accountability, has been greatly improved.

The current best practice of central banking is therefore characterised by a high degree of transparency; in its pursuit, communication has gained a vital role.

Central banks nowadays communicate more precisely what goals they want to achieve – for instance, they have often quantified the definition of price stability, most prominently in the case of inflation targets. Furthermore, central banks generally inform the public about the macroeconomic models that underlie their economic analysis. Also, they release substantially more and clearer information on the current analysis - they often release their internal forecasts of inflation and other macroeconomic variables, and explain their monetary policy decisions in press conferences or through timely releases of the minutes of the meetings of their decision-making bodies.

This wealth of information is provided in order to make the public, and in particular financial markets, a major addressee of central bank communication, familiar with the way the central bank thinks and operates.

This will make its actions more predictable, and enhance credibility. The idea that monetary policy decisions might be a surprise to the public has been substituted by the notion that a central bank should be “boring”, in the sense that it should be so well understood that all the relevant news for financial markets arises in the developments of the economy, and not in the actions or communications of the central bank.

 

Has this change affected the effectiveness of monetary policy? While most economic theory suggests that it should, it ultimately remains an empirical issue whether the benefits of increased transparency are indeed realised. A large number of research projects have been devoted to this topic recently, leading to the general conclusion that there are substantial benefits to be reaped from transparency. The explicit formulation and in particular the quantification of the central bank’s goals provides a good yardstick for economic agents to align their inflation expectations. As a matter of fact, inflation expectations are generally well anchored under such regimes; as a result, they tend to be considerably less responsive to news, and depend far less on actual inflation outcomes. Most importantly, however, stable inflation expectations facilitate the task of the central bank substantially, triggering a virtuous circle. As a result, quantitative targets for monetary policy are clearly associated with lower and more stable inflation.

At the same time, increased transparency has made central banks more predictable. This is particularly relevant for financial markets, where mispredictions of central bank actions can be extremely costly. Central banks have leverage over short-term interest rates, and as such can affect financial market outcomes. It is therefore in the interest of financial market participants to stay tuned to central bank communication, and recent research clearly shows that financial markets listen and react to it.

 

In sum, there is clear evidence that having the public in tune with the central bank, economic outcomes can be substantially improved, to the benefits of both. On the one hand, the central bank’s task of maintaining the stability of its currency is facilitated through well-aligned inflation expectations; on the other hand, knowing about the central bank’s intentions has led to more efficient pricing in financial markets. Yet, are there limitations to the benefits of transparency and the role of communication?

Substantial progress has been achieved in conveying to the public how central banks think and act, accompanied by the build-up of credibility.

However, credibility can be lost very quickly. In particular, communication is not a substitute for action. Central banks do therefore need to ensure continuously that credibility is maintained, and that inflation expectations remain anchored. We will certainly witness further steps towards increased transparency of central banks, even though unlimited transparency will not be reached, either. We should expect to see central banks moving towards more transparency in a gradual way, as done in the past, allowing them to explore the effects of any further steps on economic outcomes, and to probe what might be considered an “optimal” degree of transparency.

 

 

* The views expressed in this article are the author’s and not necessarily shared by the European Central Bank.

 

 

 

Fynn Kydland and Edward Prescott (1977). Rules Rather Than Discretion: The Inconsistency of Optimal Plans. Journal of Political Economy 85, pp. 473-490.

 

Otmar Issing (2005). Communication, Transparency, Accoutability: Monetary Policy in the Twenty-First Century. Federal Reserve Bank of St. Louis Review, pp. 65-83, research.stlouisfed.org/publications/review/05/03/part1/Issing.pdf.

 

William Poole (2004). Speech on “FOMC Transparency”, stlouisfed.org/news/speeches/2004/10_06_04.html.