Central banks have long been associated with secrecy. But over the last decade, this has gradually changed, and transparency has now become one of the key features of monetary policy. Writing in the latest issue of the Economic Journal, Petra Geraats surveys the burgeoning research evidence of the value of central bank transparency in controlling inflation.
The main findings are that:
- The delegation of monetary policy to an independent and transparent central bank has established itself as the new best practice.
- Theoretical research suggests that two key benefits of transparency are the reduction of private sector uncertainty and the improvement of incentives facing monetary policy-makers.
- Empirical evidence indicates that central bank transparency is relevant and beneficial.
Transparency finds widespread support among central banks, not only in developed countries, where it all started with New Zealand, Canada and the UK, but also in emerging markets like Brazil. In fact, a recent survey shows that 74% of central banks consider transparency a vital or very important component of their monetary policy framework.
The theoretical literature suggests that transparency has two kinds of effects: uncertainty effects and incentive effects. First, transparency reduces ''information asymmetries'' between the central bank and the private sector, that is, differences in the information they possess about the state of the economy and the prospects for monetary policy decisions. Some researchers have suggested that the disclosure of additional information could lead to more variability of private sector inflation expectations and negatively affect the achievement of stable inflation. But central bankers do not seem to be concerned about this and cherish the advantages of reduced private sector uncertainty.
Second, transparency could alter the incentives that central banks face as they attempt to overcome information asymmetries and influence private sector perceptions. For example, suppose a central bank is either responsible or inflationary, and that the public uses policy actions and outcomes to assess the central bank''s type. Then, transparency would quickly expose an inflationary type and cause the private sector to increase its inflation expectations. Since this negatively affects the central bank''s policy options, it tends to behave more responsibly. So, transparency results in lower inflation.
Furthermore, for independent central banks, the benefits of transparency include not only a reduction of private sector uncertainty, but also greater flexibility to stabilise economic disturbances, a reduction of output volatility and a closer alignment of central bankers'' actions to socially optimal behaviour. The empirical literature on transparency is still limited but has already yielded some interesting results. In particular, it provides evidence that central banks possess private information about the state of the economy that is relevant for monetary policy decisions. This indicates that the issue of central bank transparency has practical relevance. In addition, empirical evidence shows that transparency indeed has beneficial effects as it reduces inflation and the financial markets'' response to monetary policy.
Finally, one might be tempted to believe that transparency is simply a consequence of the delegation of monetary policy to independent central banks, which requires accountability and therefore openness to safeguard democratic legitimacy. But it appears that central bank transparency goes far beyond accountability requirements.
Furthermore, independence actually makes transparency beneficial since central banks no longer have a motive to envelop themselves in secrecy to obtain insulation from political pressures. This suggests that transparency has been adopted for economic reasons. As a result, the prevailing paradigm in monetary policy is best characterised
as central bank independence and transparency.
''Central Bank Transparency'' by Petra M Geraats is published in the November 2002 issue of the Economic Journal. Geraats is in the Faculty of Economics and Politics at the University of Cambridge.