Important features of monetary policy
Today, Central bank transparency has become one of the important features of monetary policy. During the past 20 years, central bank has made a tremendous change in its policy of disclosure from being highly confidential to a state of full disclosure. Transparency is now a widely accepted broad goal to which all central banks are bound to perform. The following assignment gives an explanation to the transparency of central banks and its importance in practice. The theoretical perceptions are also compared to the various ways in which central banks have become transparent in practice.
Central bank as the term indicates is a bank of treasury and the bank for the external sector of the economy. It regulates the flow of money supply and maintains the soundness of financial sector. As the bank of banks it has many diverse functions and therefore it possesses huge importance in a country. Therefore a central bank requires independence and transparency in its operations.
The new touchstone in monetary policy of central bank appears to be independence and transparency. Although the importance of central bank independence has long been recognized however research in favour of transparency of monetary policy is relatively new and largely seems a response to the new best practice in central banking. Most economists agree that greater transparency in monetary policy is desirable because it allows making better that is, welfare improving decisions, as well as better informed decisions (Blinder, 1998). But not all agree. Some argue that incomplete transparency is optimal, as the effect on the Central Bank's reputation and its consequent ability to control inflation has to be balanced against the private sector's wish to see output, employment and prices stabilised (see for example Faust and Svensson, 2001 or Jensen, 2000). Others argue that certain restrictions on transparency are important for operational reasons. Once again the idea is to reinforce the Bank's credibility (see Eijffnger and Hoeberichts, 2002) and to separate 'the need to know' from 'the need to understand' (Issing, 1999).
Central bank transparency could be defined as a balanced information flow between monetary policymakers and other economic agents. Therefore it reduces uncertainty and this is often believed to be beneficial (although it need not be).
An increase in central bank transparency can be seen by observing the past two decades of functioning of central bank. Practically, many Central Banks have actually increased their transparency. Prominent examples can be of the central banks of the United Kingdom, New Zealand, Sweden and Canada that took on a framework of 'Inflation Targeting' in the early 1990's, which is characterized by an explicit inflation target and the publication of inflation forecasts. Others such as central bank of Brazil, the European Central Bank (ECB), and even well established central banks like those of the United States, Japan and Switzerland have adopted greater transparency as well by using inflation forecasts, extensive explanations of the reasoning behind their decisions, and sometimes voting records on policy decisions. In addition the evidence in support of central bank transparency as one of the important features of monetary policy is documented in the 1998 survey of 94 central banks by Fry, Julius, Mahadeva, Roger and Sterne (2000), it explains that 74% of central banks consider transparency as very important component of their monetary policy framework, only surpassed by central bank independence and the maintenance of low inflation expectations (with 83% and 82%, respectively; Fry et al. (2000, p. 135)).The changes made by central banks suggest that the relevance of transparency has only increased. Due to increase in transparency there has been also an increase in faith for the central bank, which works for welfare for the economy of a country but also because of this increase in transparency there have been unlikely many events which were of temporary basis but lead to decrease in confidence level among the investors across the globe causing malfunctioning in an economy or throughout the world.
This assignment is structured in various parts; the first section describes about transparency and tries to explain its importance. The second section explains about transparency in central banks and practical incidents which were exposed because of transparency in addition to it there is an explanation on different types of transparency and their functions as related with central bank's monetary policy. Derived evidence on the impact of transparency is discussed in the next section. Section 4 provides a detailed discussion on accountability of central bank, and addresses the different grounds for central bank transparency; it also defines the relationship between central bank independence and transparency. Lastly there is a detailed conclusion on transparency in context of central bank.
In a general view transparency can be said as an object physical property where light can pass through allowing one to see through it. In terms of concepts, transparent means clear; therefore in a nutshell, it conveys a positive attribute. In terms of economy, transparency means the presence of symmetric information, lack of transparency in economy means asymmetric information flow which leads to uncertainty. However, transparency does not mean complete certainty. For example, in the case of monetary policy, the central bank and private sector could both face uncertainty about the structure of the economy but, as long as both have the same information and are aware of it, transparency exists. This definition lays stress on information that agents actually have, not on the act of disclosing information. The reason is that public availability of data need not be adequate to achieve transparency. If manipulation of data is required to extract useful information and agents are constrained by limited resources, then asymmetric information could persist.
This is further discussed in the context of monetary policy by Winkler (2000), as according to him transparency is in terms of openness and mutual understanding.
To understand the importance and effects of transparency it can be distinguished in two cases:-
- When there is lack of transparency or asymmetry of information it generates mistrust and undermines the effectiveness of the institutions; Lack of transparency hides actions which benefit some groups at the expense of others and is also used as a way of hiding mistakes and misguided policies.
- In the case of full transparency there are certain exceptions. There are times when there are events which can represent the deficiencies of a bank such events can be quickly repaired but due to full transparency such events lead to run on the bank. There are also national security exceptions.
As per late Patrick Moynihan said in his book Secrecy "that exception has been abused, and that has its costs which may exceed the benefits."
Central Bank Transparency
As discussed above it can be observed that transparency is a sensitive area.
Central banks are more transparent now days, as opposed to those who believed central banks activities should be kept confidential; none of the fears have actually happened. One such important incident during the starting of the recession recently which had its impact around the globe was when the federal reserve of the United states were unwilling to disclose the recipients of the AIG funds. When the disclosure was done it showed their reasons for unwillingness, with the largest recipients being Goldman Sachs and a couple of foreign banks. With so much of the money going to systemically significant institutions, questions were obviously raised about the supposed rationale for the massive bailout.
This incident represents the importance of central bank transparency. Since transparency could relate to any area of monetary policymaking, it is beneficial to use a conceptual framework that reflects the different stages of the policymaking process.
In view of Geraats (2000) transparency can be categorized in to five types namely-political, economic, procedural, policy and operational transparency. Each of these could give rise to different motives:-
- Political transparency refers to openness about policy objectives and institutional arrangements that clarify the motives of monetary policymakers. This could include explicit inflation targets, central bank independence and contracts.
- Economic transparency focuses on the economic information that is used for monetary policy, including economic data, policy models and central bank forecasts.
- Procedural transparency describes the way monetary policy decisions are taken. This includes the monetary policy strategy and an account of policy deliberations, typically through minutes and voting records.
- Policy transparency means a prompt announcement and explanation of policy decisions, and an indication of likely future policy actions in the form of a policy inclination.
- Operational transparency concerns the implementation of monetary policy actions, including a discussion of control errors for the operating instrument and macroeconomic transmission disturbances.
As it is can be clearly seen from the fact that central bank transparency has its own importance it is useful to see empirical evidence of its significance.
There are various approaches that support the argument such as-
- The measurement of transparency to find out that to what extent information relevant to monetary policy is available publicly. In support of this, the views of Leiderman and Svensson (1995) provide an overview of the initial experience with explicit inflation targets. Bernanke et al. (1999) also gives detail information on inflation targeting and give a description of the monetary policy frameworks of nine countries. In addition to it a central bank transparency index is presented by Eijffinger and Geraats (2002). This index covers the five aspects of transparency explained in above section which are namely- (1) political, (2) economic, (3) procedural, (4) policy, and (5) operational transparency, and is calculated for nine central banks.
- The second approach is to analyze the reactions of financial market to information disclosures. When there are disclosures relating to monetary policy of an economy the market or in specific financial markets reacts to the announcements, these reactions can either be positive or negative depending on what way does the market take them, this suggests they convey news and transparency prevails. In an event study analysis by Muller and Zelmer (1999) it came in to the view that the disclosure of monetary policy reports in Canada gave rise to a response in exchange rate. Also Clare and Courtenay (2001) analyzed the behaviour of UK markets whenever there was the release of monetary policy decisions and macroeconomic data. As per their findings since independence of the Bank of England there have been changes in the effects on exchange rates and equity and interest futures.
- To see the effect on monetary policy of confidential information, the approach is necessary to analyse whether it is applicable to hold private information for monetary policy and the below findings of thorough research done by authors support the fact. There are two studies that gives a detailed outlook of the issue.
- The effects of central bank transparency on macroeconomic level is essential but the analysis of the effects of transparency is hard as there are only few quantitative measures. The study by Bernanke et al. (1999) surpasses these limitations and initializes a case study approach to investigate the outcome of inflation targeting. They had research focused on countries like Germany, Switzerland, New Zealand, Canada, the United Kingdom, Sweden, Israel, Australia and Spain. The conclusion of the research is that inflation targeting seems to be beneficial.
It also appears that there is a least effect of macroeconomic announcements on equity and bond futures, which might reflect greater confidence in monetary stabilization also the interest rate futures seem to respond less to monetary policy actions.
The above reflects monetary policy to possess greater predictability of and can be said as an indication of transparency.
In view of Peek, Rosengren and Tootell (1999) macroeconomic forecasts in the U.S. can be improved by using private data on supervision of banks because as per their findings monetary policy actions are affected by confidential data on bank supervision.
The second study is in view of Romer and Romer (2000), commercial forecasts in the United States were always overcome by Federal Reserve Staff forecasts of inflation and output which are disclosed with a five-year lag. They argue that this asymmetrical information is because of huge resources which are used for Federal Reserve Staff forecasts. Also as per their findings confidential forecasts information are included in monetary policy actions.
Research by Kuttner and Posen (2000) study whether variations in monetary transparency caused changes in exchange rate volatility in the United States, Germany and Japan. As per there research increased transparency of the US Federal Reserve has contributed to a more stable exchange rate between the deutsche mark and the dollar.
In addition to it, Chortareas, Stasavage and Sterne (2001) use an alteration of the Fry et al. (2000) (sub) index of the publication of forward-looking analysis for 87 countries and gives an interpretation that higher transparency decreases average inflation. The result is stronger to the inclusion of macroeconomic features and institutional characteristics, but it does not hold for countries with an exchange rate.
Also Cecchetti and Krause (2001) study focus on a macroeconomic performance measure based on the variability of inflation and output, they also analyzed the effect of monetary framework characteristics which includes central bank independence, accountability, transparency and credibility.
There research found that macroeconomic performance appear to improve due to credibility and to a lesser extent transparency.
It can be observed that there is still a need for further research to find logical conclusion of central bank transparency.
Central Bank Accountability
It is mostly said and stated that there are two different grounds for central bank transparency
- Economic benefits
- Democratic accountability (e.g. Blinder et al. 2001).
Accountability has become important as more and more countries during the past decade transfer the responsibility of monetary policy to independent central banks.
Therefore it is quite logical that some extent of transparency is a necessary condition for accountability, but it is not justified because transparency means mere disclosure and accountability (in terms of central bank) involves having authority for monetary policy actions and possibly bearing the responsibility when policy appears defective.
Hence, central bank's incentives are directly affected by accountability; on the other hand transparency's incentive effects operate indirectly through private sector expectations.
Transparency could support accountability of monetary policy in several ways:-
Political transparency as in the context of formal objectives, targets in quantity and clarity about the institutional structure is the most essential as it provides a measure for the evaluation and identifies the responsible person/entity. Economic, procedural and policy transparency enable verification of policy actions motivation and thereby ex ante accountability of policy. Operational transparency about disturbances in transmission which contributes to ex post accountability based on outcomes of policy.
There are a few measures of accountability of monetary policy. Briault, Haldane and King (1997) construct a central bank accountability index for fourteen industrialized countries based on parliamentary monitoring, the release of minutes, the publication of a monetary policy report, and the existence of an override mechanism.de Haan, Amtenbrink and Eijffinger (1999) produced an indicator for accountability of central bank for sixteen industrialized countries that apprehends
- an explicit definition and ranking on objectives of monetary policy.
- transparency through monetary policy reports, minutes and a public evaluation of policy
- the responsibility for monetary policy reflected by parliamentary monitoring, override mechanisms and dismissal procedures.
The central bank accountability index by Fry et al. (2000) lays emphasis on
- Accountability with respect to a specific target,
- Accountability to public.
These measures have 1 thing in common that they combine aspects of both transparency and responsibility. In one way accountability may explain the emergence of transparency soon after the central bank independence. Thus, there appears to be a positive relation between central bank independence and transparency across countries. However, the arguments that this is due to accountability are less.
The central bank is the bank of the banks and lender of the last resort, it regulates the flow of funds in the economy, and hence this signifies the importance of a central bank in the economy, due to such huge authority, it also is accountable to the economy, to the govt. And last but not the least to the public. There have been many arguments among various economists regarding central bank transparency, some said there should be full transparency, some said there should be no transparency at all and some of them had the opinion that transparency should be the least transparency as possible. But amidst of all these central banks of many nations carried out their responsibility of disclosing their activities to the public from being at the point of treating every activity to be highly confidential to disclosing almost each and every activity as of today.
Transparency can be said as a very sensitive tool as discussed above when there is a lack of transparency by the central bank there it undermines the effectiveness of the institutions; Lack of transparency hides actions which benefit some groups at the expense of others and is also used as a way of hiding mistakes and misguided policies and similarly due to full transparency there are times when incidents are of short term but because of transparency being at the highest level the incidents being small causes large reactions inside the economy. Since transparency being very fragile it could relate to any area of monetary policymaking of central bank, it is beneficial to use a conceptual framework that reflects the different stages of the policymaking process namely political, economic, procedural, policy and operational. These different aspects of transparency are used in an effective way actually for better policy outcomes so that economies can constantly grow. Although the theoretical research has developed a lot, yet there is no general agreement on the economic desirability of transparency of monetary policy but still, the theoretical research has also provided some arguments why transparency can be desirable when central banks are independent and inflation problems absent. In more of a particular way, the greater central bank transparency the more there will be reduction in private sector uncertainty; this could provide the central bank higher flexibility to control economic disturbances. In the view of empirical evidences provided all approaches are distinct and important in their own way. The work that is available suggests that transparency tends to be in the form of benefit. Hence these empirical evidence gives support for policy recommendations like the "Code of Good Practice" from the International Monetary Fund (1999).
- Blinder, Alan, 1998, Central Banking in Theory and Practice, MIT Press, Cambridge, MA.
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- International Monetary Fund (1999), 'Code of good practices on transparency in monetary and financial policies', http://www.imf.org.