Central Bank Transparency and the Signal Value of Prices

A central bank must be accountable for its actions, and its decisionmaking procedures should meet the highest standards of probity and technical competence. In light of the considerable discretion enjoyed by independent central banks, the standards of accountability that they must meet are perhaps even higher than for most other public institutions. Transparency allows for democratic scrutiny of the central bank and hence is an important precondition for central bank accountability. Few would question the proposition that central banks must be transparent in this broad sense.

A narrower debate over central bank transparency considers whether a central bank should publish its forecasts and whether it should have a publicly announced, numerical target for inflation. This narrower notion of transparency also impinges on issues of accountability and legitimacy, but the main focus in this debate has been on the effectiveness of monetary policy.

Proponents of transparency in this narrower sense point to the importance of the management of expectations in conducting monetary policy. A central bank generally controls directly only the overnight interest rate, "an interest rate that is relevant to virtually no economically interesting transactions," as Alan Blinder has put it.¹ The links from this direct lever of monetary policy to the prices that matter, such as long-term interest rates, depend almost entirely upon market expectations, and monetary policy is effective only to the extent that the central bank can shape the beliefs of market participants. Long-term interest rates are influenced in large part by the market's expectation of the future course of short-term rates. By charting a path for future short-term rates and communicating this path clearly to the market, the central bank can influence market expectations, thereby affecting mortgage rates, corporate lending rates, and other prices that have a direct impact on the economy. Having thus gained a lever of control over long-term rates, monetary policy achieves its effects through the IS curve, through quantities such as consumption and investment.

Indeed, it would not be an exaggeration to say that many leading monetary economists today see the management of expectations as the task of monetary policy. For Lars Svensson, "monetary policy is to a large extent the management of expectations"; Michael Woodford puts it similarly: "not only do expectations about policy matter, but, at least under current conditions, very little else matters."²

The reasons for this preeminent role of expectations in monetary policy are explained particularly well for a general audience in a policy speech by Ben Bernanke, titled "The Logic of Monetary Policy."³ Bernanke considers whether monetary policy's steering of the economy is in some way analogous to driving a car. Monetary policy actions are akin to stepping on the accelerator or the brake, to stimulate or cool the economy as appropriate given its current state. Bernanke notes that, although this analogy is superficially attractive, it breaks down when one notes the importance of market expectations of the central bank's future actions. If the economy is like a car, then it is a car whose speed at a particular moment depends not on the pressure on the accelerator at that moment, but rather on the expected average pressure on the accelerator over the rest of the trip. Woodford employs a similar transport metaphor: "central banking is not like steering an oil tanker, or even guiding a spacecraft, which follows a trajectory that depends on constantly changing factors, but that does not depend on the vehicle's own expectations about where it is heading." Instead, optimal policy is history dependent, in that the central bank commits itself to a rule that takes into account past conditions, including even some that no longer matter for an evaluation of what is possible to achieve from now on. This is so because it was the anticipation of such a rule that determined the market's expectations today.⁴

The pivotal role of market expectations puts the central bank's communication policy at center stage, and this view has been adopted to some extent by all central banks, but embraced...