Making monetary policy less opaque

It is fair to note that most citizens care little for monetary policy. The average citizen typically does not understand monetary policy, and they make little effort to grasp what they perceive as an arcane world which speaks mostly unintelligible words. The average citizen does care about price stability, however, and would react strongly to a return of high inflation. They routinely care about interest rates, but would not seriously feel a difference of 50 basis points. In small open economies, they are keenly aware of the exchange rate. In the end, they typically see central banks as affecting growth and employment, which may explain why most central banks try to distance themselves - mostly unsuccessfully - from the real economy. This lack of interest and monitoring ability does not result in a carte blanche being handed to the central bank. 

Even very independent central banks are unlikely to overlook public sentiment, and in many countries their very independence is at stake. They must create and maintain an impression of competence and of understanding that generates quiet acquiescence. The high degree of acceptance of the Bundesbank is widely linked to its successful efforts at finding ways of talking to and being understood by the broader public. To that effect, central banks need to use all available communication channels. They often publish pedagogical brochures, for instance. But the main effort is clearly in the direction of the media, in particular those that appeal to the educated public. Central bankers routinely make themselves available for press conferences, interviews and background briefings. They usually freely provide data and analyses. All central banks now have websites with a rich, often nearly exhaustive content. A particular challenge is that some media are specialised in financial affairs but are mostly read by an educated public, while most citizens receive their information from non-specialised media. Communication with the specialised media comes naturally, and is often more than adequate. Communication with the non-specialised media, and therefore with the majority of citizens, is considerably more difficult.

PROBLEMS THE MEDIA FACE: In dealing with monetary policy the media face two problems. First, they need to create and maintain interest in a technical subject. Simplification and pedagogy are essential ingredients here, but the risk is to lose nuance, a key ingredient in central bank communication. This is especially the case with television, the most influential of all media, where a few minutes, often seconds, are devoted to any piece of news, leading to the search for 'sound bites.' Central bankers naturally fear this form of communication, which can easily lead to misquotation. The resulting vicious circle - from rarefied communication to lack of interest and understanding, back to scarce information - is obviously hard to break. Much as politicians have honed their communication skills over the last decades, policy-makers and central bankers will also need to learn the trade. The current situation is unsustainable.

Second, the central bank is a monopolist in the production of monetary policy, but it should not enjoy monopoly in discussions of monetary affairs. The media need to diversify their sources of information and analysis. Much the same concerns government, but there the media can always turn to opposition politicians. Because the media will always seek contrary views, central banks need well-informed critics who challenge their words and their deeds. In some countries there exist self-appointed shadow monetary policy committees. In general, central banks would be well-advised to feed with as much information as possible to a wide group of experts, if only to avoid debates born out of ignorance of what they do and think. We discuss the role of central bank watchers below.

CONFLICT OF INTEREST: Governments and parliaments represent the citizens. But they may also have their own agenda, precisely because of the limited interest of citizens for monetary affairs. Governments are keenly interested in monetary policy because of shared responsibilities (e.g. the exchange rate) and shared impact on both inflation and economic activity. Most crucially, economic conditions often play a decisive role in elections, so governments - and the opposition parties - have a clear view of what they would like the central bank to do over the preceding period. Conflict of interest is the norm and this is why independence is crucial. Independence, now the norm rather than the exception, slightly complicates matters. 

On the one hand, independence carries responsibility for central bank's unelected officials. With responsibility comes accountability to elected officials. Central bank accountability is generally established in its statutes. In most cases, the central bank is formally accountable to parliament. On the other hand, independence requires an arms-length relationship between central banks and politicians. Some central banks are forbidden by law to take instructions from any outsider. In that case, accountability must balance independence and democratic control.  In some countries, the central bank is only instrument-independent. In that case, the minister of finance formally sets its policy objective, and the minister's right to influence the central bank stops there. Parliaments are usually the custodians of central bank behaviour, implying formal reporting. In some countries (e.g. the United States and the United Kingdom) parliamentary oversight is backed by the right to amend the statutes and/or the procedures of the central bank. This gives weight to parliamentary control and provides an effective tool of communication between the central bank and the elected representatives. In others, the Euro area being a good example, parliament can only engage in a 'dialogue' with central bank officials, but cannot affect its statutes and objectives.

Unless the relevant committee is equipped with a strong supporting staff (which the Euro Parliament is not), auditions of central bank officials are an exercise in formalism. This leaves the central bank free to decide whether the formal reporting is a useful tool of communication. Whatever the institutional set-up, transparency greatly enhances central bank's independence vis-à-vis politicians while furthering the goal of accountability. The more open the bank is, the less can it be amenable to government political pressure. Greater transparency also contributes to lessening the impact of institutional shortcomings, be it excessive or insufficient power of parliament.

FINANCIAL MARKETS: Financial markets have an intense interest in money matters. Monetary policy represents the single most important parameter affecting their performance. Financial institutions retain on their staff people well aware of the technical details of monetary policy, indeed personnel often move freely from one to the other, at all levels of responsibility. Crucially, the financial markets constitute the channel through which monetary policy actions are transmitted to the economy, and ultimately achieve its goals. Since this channel is dominated by expectations, 'convincing the markets' is part and parcel of monetary policy-making. It is not surprising, therefore, that central bank communication is largely, sometimes almost exclusively, directed at the financial markets. 

A few observations are warranted. The health of the financial system is a key responsibility of central banks. When they design their policies, central banks can never overlook their impact on financial markets. There may even be instances where threats to financial stability lead central banks to modify their policies, as was the case during the 1998 crisis. On such rare occasions, central banks are usually highly reluctant to recognise such a state of affairs. They feel that their carefully designed strategy, the focal point of their communication efforts, would lose credibility if they were seen as responding to the whims of the markets. But credibility is most hurt whenever words and deeds conflict. Many believe that in the rare circumstances where concerns for financial stability lead them to adjust their policy, central banks ought to make it publicly known. Suspending a strategy for good reasons cannot hurt.

What is good for markets is not necessarily good for the public. The markets thrive on volatility while the public dislikes it quite intensely. The markets operate on a very short-term horizon, from a few seconds to a few months, while the public's limited interest in monetary affairs starts with the time it takes for monetary policy to have real effects, i.e. several quarters. The markets ultimately see monetary policy as affecting their bottom lines, but monetary policy has wider redistributive and therefore political implications. The danger, then, is that central banks become too pre-occupied with their communication to the financial markets and occasionally overlook their other constituencies. This danger diminishes the more open a central bank is - for two main reasons. First, transparency reduces the market value of central bank information, which allows for a more arms-length relationship with the financial markets. Second, transparency allows outside, reasonably neutral observers to interfere if the relationship were to become too cosy.

CENTRAL BANK WATCHERS: Central bank watchers can be found in financial market institutions, the media and academia. Their expertise lies either in sharing with central bankers the same technical background or in having developed a sense for interpreting official pronouncements. They play an important role in interpreting central bank actions, disseminating and deciphering for the broad public the information released by central banks. They provide alternative opinions, lessening the monopolistic power of central banks. They often earn a living in anticipating future decisions, thus contributing to the transmission role of financial markets. In brief, they are part of the communication system of central banks.

 For a central bank, its dedicated watchers are both friends and foes. They are friends since they disseminate, clarify and sometimes justify its actions. Their reactions can also serve as a useful sounding board. They are foes because they can be critical, or because they can outguess actions that the central bank would rather not divulge, at least not yet. Thus central banks wish to establish good relationships with their watchers, while keeping them at arm's length.

Transparency is a mixed blessing for central bank watchers. Those more adept at interpreting nuances stand to lose from openness. The others stand to benefit to the extent that their role is not limited to deciphering ambiguous signals, but extends to interpreting and commenting upon policy choices. From the central bank's viewpoint, transparency helps reduce the risk of misinterpretation. It allows for better feedback once the watchers are not seeking to extract secrets. The downside is that it prevents central bankers from co-opting friendly watchers by feeding them with privileged information. But the benefits of such a strategy are dubious since, for every co-opted friend there must be a disgruntled foe. Here again transparency is beneficial, to both the central bank and its best and most disinterested watchers.

CONCLUSION: Economists are instinctually of the view that more information is better. They argue that having a central bank more fully communicate its objectives, its assessment of the effects of policy actions, and information about economic conditions will enhance social welfare. Policy being more predictable, agents will be better able to align their decisions with those of the central bank. The economy will adjust more smoothly insofar as they can more accurately forecast the time paths of relevant variables. 

By the same token, the theory of the second best suggests that removing one distortion may not always lead to a more efficient allocation when other distortions are present. Adding distortions, theorists have thus provided counterexamples where greater transparency may not lead to a welfare improvement. 

The economics literature has identified the potential costs of greater transparency about policy goals and intentions-an overemphasis on inflation stabilisation 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.

Jamaluddin Ahmed PhD, FCA is General Secretary, Bangladesh Economic Association.

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