Transparency of Monetary Policy: Optimal Level
According to the principle of inflation targeting, central bank policy should be transparent. In other words, there should be no information asymmetry between the monetary authorities and the public.
Macroeconomists generally agree with this principle, but there is much room for interpretation in how this is implemented in practice. To what degree should one show one’s cards?
I, for one, often attend thesis defences. On the one hand, there is a common understanding that the process should be transparent enough that the student can learn the opinion of the board of examiners on his or her paper and get his or her mark. On the other hand, if the examiners argue with one another during the discussion and vote for different marks, the student will be very likely never to know who is against giving him or her an excellent mark. Most teachers would agree that this degree of transparency would be inappropriate in this case, and examiners normally prefer to show the student a consensus.
The case of monetary policy appears to be similar. All central bankers who are targeting inflation announce the policy rate they have decided to set and why. Only a handful of them let their audience know the opinion of each of the directors during the discussion and whose arguments have finally prevailed. Most central bankers stick to the ‘one voice policy’ (link in Russian) in their communications.
There are different levels of transparency. The degree of disclosure of the decision-making process described above is called ‘procedural transparency’. Another type of transparency which is currently debated by global policymakers is ‘strategic transparency’, in which the central bank informs the public about its future actions. For instance, should monetary authorities publish information on the future policy rate path? Opinion on this matter has changed considerably in the last few years even within the Bank of Russia alone.
In this brief, I will try to reflect the current debate on the optimal transparency of monetary policy.
Why is it good to have a transparent policy?
The most fundamental argument for the transparency is based on the first welfare theorem. It describes the conditions for achieving Pareto efficiency (a situation in which resources are allocated in the most efficient way and can no longer be reallocated in a way that makes one party better off without harming other parties). One of its conditions is that there be no information asymmetry between economic agents. Obviously, the more transparent the policy is, the less asymmetry there will be.
A more practical point contemporary central bankers rely on when increasing the transparency of their policies is that this decision enables them to have better control of the inflation expectations of businesses and households. The more clearly economic agents understand the central bank’s objectives and its strategies to achieve them (or the less noise they get in information), the closer their inflation expectations are to the target set by the monetary authorities. For example, in our study (link in Russian), we show that a more transparent policy makes economic agents’ expectations less responsive to exchange rate fluctuations in the foreign exchange market. This means that a weakening of the national currency has a smaller effect on prices, helping the central bank control inflation better.
If monetary policy is not transparent, the monetary policy transmission mechanism works poorly. Bernando Candia from the University of California at Berkeley and his co-authors have shown that this happens due to the misinterpretation of shocks faced by the economy, i.e., when firms and households do not have enough information, they tend to confuse demand inflation (price growth on the back of larger aggregate demand during economic boom periods) with cost inflation (price growth prompted by a smaller supply due to higher production input costs). As a result, economic agents form incorrect expectations, preventing the economy from stabilising.
Why is it bad to have too transparent a policy?
Although the overall transparency of monetary policy is gradually increasing world-wide, there remain a number of arguments against excessive transparency.
Excessive operational transparency, such as the disclosure of the minutes of policy rate meetings, may lead to a whole range of negative consequences: the highlighting of disagreements among the directors undermines the authority of the central bank, making the logic it uses and the decisions its takes less understandable to businesses and households. Being aware that their opinions will be published, the members of monetary policy committees become susceptible to various behavioural effects. Sebastian Fehrler from the University of Bremen and Niall Hughes from King’s College, London, have found that these effects may result in less effective decision making. For instance, if the members of the committee are re-elected based on their activity, the less qualified members may not remain silent during discussions, which would make it more likely for the committee to take an incorrect decision.
Excessive strategic transparency when a central bank publishes detailed information on its projections and the steps it will take in one situation or another may also be harmful. Carin Cruijsen and Sylvester Eijffinger from Tilburg University have discovered that behavioural effects again play an important role, bounded rationality in particular. If a central banker provides businesses and households with too many reports, minutes, and projections, economic agents may get confused. One short message with a simple and clear signal, e.g., ‘Inflation risks in the economy are high, so we are increasing the policy rate’, may be a better solution in terms of managing inflation expectations than a detailed analysis of the economic situation that covers all the nuances.
In addition, the latter may discourage businesses from making their own analyses of the state of the economy. When making pricing and output decisions, they may rely on the central banker’s signal to a greater extent than on their own assessments, potentially decreasing the quality of their decisions. Firms usually know much better than the central bank what is going on in their sectors, so their own analysis should also be helpful.
What does it mean for monetary policy?
Our study (link in Russian) examines panel data on 32 countries applying inflation targeting. We attempt to understand how the chosen degree of monetary policy transparency affects the likelihood of achieving the inflation target.
To measure transparency, we use an index proposed by Nergiz Dincer (TED University, Ankara) and Barry Eichengreen (University of California, Berkeley). The index takes values from 0 to 15 and is arranged such that a central bank gets a score from 0 to 1 on each of 15 criteria depending on how often it releases projections, discloses the voting results of its board of directors, etc. For instance, if a central bank does not publish any projections of macroeconomic variables at all, it gets a zero score for this criterion. If it releases inflation and output projections at least occasionally, it gets a score 0.5. At the maximum, if a regulator discloses detailed quarterly quantitative forecasts of inflation and production output, it gets the full score. Thus, the maximum index value indicates that the policymaker discloses all the inner workings of its decision making.
Our calculations show that in the beginning, as the transparency of monetary policy increases, the likelihood of achieving the inflation target also rises. This therefore confirms the hypothesis that more transparent policy enables policymakers to manage inflation expectations better, with price growth rates approaching the desired target. However, the effect wears off when the transparency index reaches a certain threshold (around 10–12 points on the scale of Dincer and Eichengreen), and a further increase in policy transparency may be even bad for the effectiveness of inflation targeting. This means that there may indeed be such a thing as too much transparency.
The Bank of Russia has come a long way in changing its own manner of communication with businesses and households. It started with scores of just a couple of points in the late 1990s to scores of 7.5 at the time of the switch to inflation targeting. Now, the Russian monetary authorities have surpassed the mark of ten points to be within the confidence interval for the optimal transparency of monetary policy. However, it is about more than just technical measures. It is important to ensure the appropriate quality of communication, that is, to take care that the language and actions of policymakers are clear to people.
Why is this important? Given the current restrictions faced by the Russian economy, the Bank of Russia has a smaller than usual range of opportunities. In this situation, the quality (rather than quantity) of communication with the public has become critical for achieving price stability.
