Views on Monetary Policy Transparency

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Views on Monetary Policy Transparency

• Daniel L. Thornton
• Vice President and Economic Advisor
• Federal Reserve Bank of St. Louis
• Remarks Prepared for Central Bank Communication,
  Decision-Making and Governance
• Wilfrid Laurier University
• April 27, 2009

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Views on MP Transparency

• Monetary Policy Transparency Transparent About
  What? The Manchester School, September, 2003,
  478-97
• Transparency is good if it enhances the efficacy
  of monetary policy and bad if it doesnt
• Secrecy does not imply lack of democratic
  accountability
• If whatever the CB is being transparent about
  doesnt affect the efficacy of MP, then as a
  general rule, more transparency is preferred to
  less

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Views on MP Transparency

• The extent to which policymakers may want to be
  secret depends on both the economic environment
  and the objectives of policy
• The economic environment determines the set of
  feasible objectives as well as whether
  transparency is good or bad
• Policymakers choose among the feasible set of
  objectives to optimize some (societal) objective
  function

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Views on MP Transparency

• What is the feasible set for inflation and
  output growth?
• If there is no effect of MP on output in the long
  run, the long run the feasible set consists only
  of inflation
• If policymakers believe that there is a permanent
  tradeoff between inflation and output growth,
  they need to say what the tradeoff is and why it
  exists

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Views on MP Transparency

• What is the feasible set for inflation and
  output growth?
• In an economy where the variance of inflation and
  the variance of output are positively correlated
  or when all cyclical shocks are demand shocks,
  inflation stabilization and output stabilization
  are complements (not substitutes)

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Views on MP Transparency

• Assume
• Note that
• Assume that , ,
  which implies
• , so
  that the optimal choice of lambda is zero

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Views on MP Transparency

• Economic stabilization and inflation
  stabilization are not complements when there are
  supply shocks
• There is a question of whether the CB should
  response to supply shocks and how aggressively it
  should respond
• The CB should be clear about when and how it will
  respond to supply shocks

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Views on MP Transparency

• While there is evidence that bring inflation down
  from high levels requires temporary reductions in
  output, evidence that maintaining inflation at a
  low rate requires an output sacrifice is hardly
  compelling

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Views on MP Transparency

• CBs use of the tradeoff between stabilizing
  inflation and output depends on (a) the existence
  of a relatively stable short-run Phillips curve
  (the evidence, e.g., Stock and Watson, 2008 is
  not compelling), and (b) the ability of central
  bankers to exploit that tradeoff
• tradeoff is variable and not predictable
• variable lags in the effect of MP on output and
  inflation
• measurement problems, e.g., potential, NAIRU,
  etc.

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What CBs Need to be Transparent About

• CBs need to be explicit about their objective
  function and their view of the feasible set of
  policy objectives and the extent to which they
  believe they can achieve these objectives
• in particular, CBs should be very specific about
  their view of the optimal inflation rate and
  why this rate is optimal
• they should state whether the optimal inflation
  rate is state dependent and, if so, how and why
  it changes
• if the optimal inflation rate is positive, they
  should explain why is a little inflation is
  desirable

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What CBs Need to be Transparent About

• Having an explicit numerical inflation objective
  is critical to anchoring inflation expectations
• A numerical inflation objective is a constraint
  on too zealous pursuit of economic growth by
  policymakers and government officials.
• Economic growth is often euphemistically called
  output stabilization by those who believe the
  optimal rate of inflation is higher that the CBs
  target rate)

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What CBs Need to be Transparent About

• CBs should be forward guidance about their
  target for the long-run inflation rate, but not
  about the policy rate, monetary aggregate growth
  or other instruments that move endogenously with
  economic activity
• Forward guidance on the policy rate is not
  credible (e.g., Anderson and Hoffman, 2009).
  Economic variables are too hard to predict.

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Thank You for Your Attention!