Toward an Even More Transparent Fed

By Kim Schoenholtz, Professor of Management Practice and Director of the Center for Global Economy and Business

Kim Schoenholtz

If policymakers have a clear objective – such as anchoring inflation expectations – transparency can foster the private adjustments necessary to secure the policy goal.

Below is an excerpt from the NYU Stern Economics blog. Read the full post

January 24, 2012

Monty Hall, of Let’s Make a Deal fame, aimed for suspense, but he knew that a little transparency could add to the tension of a game show. So he told contestants what prize was behind the winning door, but not which door it was. As they selected among the three doors, anxious contestants provided titillation for TV voyeurs.

Monetary policy should not be designed to heighten suspense, nor should it be aimed at voyeurs. Yet, as central bankers around the world now affirm, transparency usually is desirable because it makes policy more effective.

If policymakers have a clear objective – such as anchoring inflation expectations – transparency can foster the private adjustments necessary to secure the policy goal. When households and firms are able to anticipate how policymakers will react to future developments, they can adjust their behavior quickly, even in the face of surprises. Similarly, rapid adjustment of financial conditions can speed policy’s impact. Because transparency makes policymakers more easily accountable, it also enhances their credibility. And it helps secure their independence, which is not feasible in a democratic society without accountability.

Reflecting this wisdom, the Federal Reserve has lifted the veil on monetary policy over the past two decades. Prior to 1994, the Federal Open Market Committee (FOMC) did not even announce if it had altered policy. A priesthood of bond market experts had to divine the policy signal from the noise of daily open market operations, most of which had nothing to do with policy setting. This complex process could take weeks, and was aimed to conceal, rather than reveal. It incarnated the secretive motto of Montagu Norman, Governor of the Bank of England from 1920 to 1944: “Never explain, never apologize.” …

To its credit, the Bernanke FOMC continues to evolve toward greater openness. On January 25, for the first time, the FOMC will publish some details about individual members’ projections of the policy rate (you can find the template and an explanation here). The goal is “to help the public better understand the Committee’s monetary policy decisions and the ways in which those decisions depend on members’ assessments of economic and financial conditions.” …

So what knowledge would be most helpful for the FOMC to reveal? Two issues come to mind. First, how do FOMC members make short-run trade-offs between their key goals of price stability and maximum sustainable employment? [In the jargon of monetary policy analysis, transparent policymakers should specify quantitatively how the “loss functions” that define their preferences weigh temporary deviations from these objectives.] And second, how do they model (forecast) the economy, including its response to policy changes? Addressing these matters could be instructive for the Committee, and might even help over time to forge a broader consensus.

Given the FOMC’s extraordinary progress over the years, it is no longer difficult to imagine policymakers eventually approaching this “gold standard” of transparency. Doing so likely would, as most policymakers avow, make policy more effective. No less important, it also could help to reduce dangerous threats to the Fed’s independence from politicians who still (incorrectly) view the FOMC as a committee of Montagu Norman’s. If so, when we look back from a future vantage point at Ben Bernanke’s years as Fed Chairman, the FOMC’s continued shift toward transparency may be seen as his greatest legacy.

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