Academic journal article Review - Federal Reserve Bank of St. Louis

Announcements and the Role of Policy Guidance/Commentary

Academic journal article Review - Federal Reserve Bank of St. Louis

Announcements and the Role of Policy Guidance/Commentary

Article excerpt

(ProQuest: ... denotes formulae omitted.)

Carl E. Walsh

By providing guidance about future economic developments, central banks can affect private sector expectations and decisions. This can improve welfare by reducing private sector forecast errors, but it can also magnify the impact of noise in central bank forecasts. I employ a model of heterogeneous information to compare outcomes under opaque and transparent monetary policies. While better central bank information is always welfare improving, more central bank information may not be. (JEL E52, E58)

Federal Reserve Bank of St. Louis Review, July/August 2008, 90(4), pp. 421-42.

Standard models used for monetary policy analysis typically assume that households and firms and the central bank share a common information set and economic model, yet actual policy decisions are taken in an environment in which heterogeneous information is the norm and many alternative models coexist. The resulting heterogeneity in views can play an important role in affecting both policy choices and the monetary transmission process. Transparency in the conduct of policy can help to reduce heterogeneous information. Inflation-targeting central banks, for example, make significant attempts to reduce uncertainty about policy objectives, such as through the release of detailed inflation and output projections, to ensure the public shares central bank information about future economy developments. By being transparent about its objectives and its outlook for the economy, central banks help provide the public with guidance about the future.

But providing guidance carries risks. As Poole (2005, p. 6) has expressed it, "[F]or me the issue is whether under normal and routine circumstances forward guidance will convey information or whether it will create additional uncertainty."

Because any forecast released by the central bank is subject to error, being more transparent may simply lead the private sector to react to what was, in retrospect, noise in the forecast. The possibility that the private sector may overreact to central bank announcements does capture a concern expressed by some policymakers. For example, in discussing the release of Federal Open Market Committee (FOMC) minutes, Janet Yellen expressed the view that "Financial markets could misinterpret and overreact to the minutes" (Yellen, 2005, p. 1).

In this paper, I explore the role of economic transparency-specifically, transparency about the central bank's assessment of future economic conditions-in altering the effectiveness of monetary policy. I do so in a framework in which central bank projections may convey useful information but may also introduce inefficient fluctuations into the economy.

A focus on economic transparency seems appropriate for understanding the issues facing many central banks. The recent concerns about the implications of the subprime mortgage market reflect, in part, private sector uncertainty about the Fed's view of the economic outlook and the way the outlook for inflation and real economic activity may be affected by financial market conditions. Throughout 2007, for example, many financial market participants appeared to hold more pessimistic views than the Federal Reserve about future economic developments;1 and in recent months, market participants have often expected significant interest rate cuts, while some members of the FOMC have emphasized concerns about the outlook for inflation, suggesting they saw less need for rate reductions. News reports speculating on possible interest rate cuts by the Fed or the European Central Bank focused very little on uncertainty about central bank preferences but a great deal on the uncertainty about the outlook for the economy. These reports reveal heterogeneity among private forecasters and uncertainty about the Fed's (or the European Central Bank's) outlook for the economy. And public statements by central bankers were designed to communicate their views on future economic developments. …

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