Does Central Bank transparency impact financial markets? A cross-country econometric analysis

Southern Economic Journal, Jan, 2007 by Marc Tomljanovich

Winkler (2000), in fact, argues that central bankers face an inherent tradeoff between honesty, clarity, and information efficiency. Any two can be achieved, but not all three. Central banks can be honest (that is, do what they say they are going to do) and clear (in their objectives or policies), thus subscribing to a simple set of policy rules, such as inflation targeting, that can easily be explained to the public and easily followed, but (internal) informational efficiency is sacrificed. Alternately, central banks could clearly state simple decision rules to the public, yet perform their own actions based on internal information, thus sacrificing honesty. Finally, central banks could focus on informational efficiency and eschew passing information to the public and any sort of rules-based policy, thus being honest yet opaque. In recent years, banks in democratic societies have moved away from the second alternative, as political accountability has become a larger issue for policymakers and the public. Thus one significant choice faced by central banks today is between clarity and informational efficiency. According to Winkler (2000), the move from the third scenario to the first scenario, and the corresponding loss of informational efficiency, is one potential downside of greater transparency.

Transparency and Financial Markets

Though openness appears justifiable on democratic grounds, the evidence is mixed concerning its impact on the economy. In particular, the release of information by the central bank and its subsequent dissemination by the public would appear to influence financial markets the most. It is an open question whether financial markets understand a central bank's decision-making process sufficiently to anticipate correctly any rate changes that are made, such that additional information potentially revealed by the bank is redundant. Until the 1990s, central bankers preferred to keep internal information from the public as much as possible, as it was feared more information could potentially destabilize national financial markets as agents attempted to forecast future central bank moves.

The U.S. Federal Reserve System was forced to defend publicly its refusal to reveal internal information during the Merrill vs. FOMC legal case in 1979. The Fed argued that secrecy was needed for the following five reasons. First, FOMC secrecy prevents unfair speculation. Second, if policy prescriptions were made public, inappropriate market reaction or market overreaction may occur if the public incorrectly anticipates the Fed's reaction to newly released information. Third, contemporaneous disclosure of policy and goals may harm the government's commercial interests by raising the cost of borrowing. Fourth, the Fed would rather not take a stand, a priori, on policy prescriptions, but would rather have the flexibility to deal with events on a case-by-case basis. Fifth, disclosure would make it harder for the Fed to smooth interest rates, as the public would react immediately to key economic indicator announcements. Thus, all of the arguments for secrecy translated into how more information could disrupt or distort financial markets.