Transparency of central bank versus democratic accountability

Central banks originated as closely held and privately owned suppliers of credit to the government. As they competed with other financial institutions, they tended to be less than forthcoming about their pricing and portfolio decisions. Because they had a privileged relationship with the state - often with the head of state himself - they treated information as confidential, known only to the bank and its client. That they were less than transparent about their decision-making is understandable given these circumstances. Transparency is the most dramatic difference between central banking today and central banking in earlier historical periods. In recent years, a number of central banks have moved in the direction of greater transparency about their objectives, procedures, rationales, models, and data. The question is whether the trend is widespread and whether it is likely to be transitory or enduring.
As part of this bargain, central banks gradually acquired their modern competency of regulating supplies of money and credit. Typically, they acquired it in the era of commodity money. The obligation of converting their liabilities into specie at a fixed rate of exchange ensured an important element of transparency in their operations. Observers knew something about the institution's objective function: the central bank assigned a high weight to the maintenance of convertibility. They knew something about the model that the central bank used, typically some variant of the price-specie flow model. They were knowledgeable of the instruments used to pursue its objectives, typically the rate at which it discounted other obligations to regulate currency fluctuations, together with ancillary measures to render that discount rate effective. They observed the success with which the central bank regulated the price of specie. Reflecting public or semi-public nature of this commitment, central banks published information on changes in gold reserves that were used by market participants to forecast future policies. In modern studies, one aspect of transparency is whether a central bank provides an explicit policy rule or strategy that describes its monetary policy framework; an exchange rate target is one such rule. So it was in this earlier period. The existence of this modicum of transparency was what made it socially acceptable to assign consequential public policy functions to entities that often had private shareholders, mixed motives, and a good deal of bureaucratic autonomy.
MEANING OF TRANSPARENCY: 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 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 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 economics literature is 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-scene' political pressures to expand employment. Over the past 20 years, a large literature has analysed the consequences for inflation when objectives of 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 minimising 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. As 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 stabilising inflation and less on stabilising output and employment. This distorts stabilisation 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 formalised 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 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 is a rate cut 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 emphasised 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 synthesised 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 framing 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 and opaqueness. 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. 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.
Jamaluddin Ahmed PhD, FCA is General Secretary, Bangladesh Economic Association.
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