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

Southern Economic Journal, Jan, 2007 by Marc Tomljanovich

Recent empirical studies involving central bank transparency find associations between increased public information issuance and improved national macroeconomic performance. Chortareas, Stasavage, and Sterne (2002) use the central bank data set compiled by Fry et al. (2000) to analyze cross-sectional relations between transparency and macroeconomic factors. Though they find evidence suggesting countries with transparent central banks also have lower inflation rates, their methodology is suspect due to the potential reversal causality issue that emerges, as countries with lower inflation rates are more likely to adopt openness measures. Using daily data, Poole, Rasche, and Thornton (2002) consider how predictable the timing and magnitude of FOMC rate moves were pre- and post-1994. They find that though the magnitude was largely known by financial markets, the precise timing of the policy action was almost never correctly ascertained before 1994. After the shift to openness, markets anticipated the direction and size of federal funds rate movements much more precisely, implying that the transparency shift did help financial market participants form more accurate future expectations. Thornton (1996) econometrically examines the consequences of the Fed's policy shift towards immediate disclosure on the federal funds rate. After 1994, much of the Fed's supposed secrecy was removed. Thornton (1996) argues that the new policy has reduced financial market uncertainty, which should result in a lower forecast error (represented by a lower Mean Squared Error) for all interest rates since 1994. He finds this is the case, though at least part of the reduced volatility may be due to relatively quiet financial markets, rather than the change in Fed policy. Recent studies that use similar methodologies include Muller and Zellmer (1999) for Canada, and Coppel and Connolly (2003) for Australia.

It is important to determine whether changes in Federal Reserve openness influence the Federal Funds market. However, it is also important to determine whether increases in efficiency in the Federal Funds market improve the efficiency of the markets for securities of longer maturities. We would like to know if changes in uncertainty regarding the Federal Funds rate influence the uncertainty regarding other interest rates. If the arguments by Cukierman and Metzler (1986) and Faust and Svensson (2002) are correct, then one would expect that increased uncertainty and reduced efficiency of the Federal Funds market may increase uncertainty and reduce efficiency in the markets which determine other interest rates. This is in large part due to the expectations hypothesis of the term-structure of interest rates, which states that other interest rates should be the appropriate average of the expected Federal Funds rate.

3. Data and Methodology

Data Description and Sources

The countries used in this analysis include Australia, Canada, Germany, Japan, New Zealand, the United Kingdom, and the United States. New Zealand and Germany were added as control countries, as no changes in central bank disclosure policies occurred in either country for the time span studied. Thus, by studying how financial markets in these two countries changed throughout the period, we may be able to determine whether the changes, if found, in the other countries were caused by the moves to openness or by other factors such as global economic conditions or faster information flows. The interest rates employed are rates on national government securities reported on the last business day of each month. (6) The monthly data were collected from both central bank websites and Bloomberg, and run from 1990:01 to 2003:05. (7) The data have been log transformed into continuously compounded interest rates. (8) Table 2 reports all descriptive statistics, including sub-period lengths. We investigate the spreads using 3-month, 6-month, 1-year, 2-year, and 3-year government bills and notes. We prefer to use common samples for all spreads within a given country; sample lengths for each country are reported in Table 2. Finally, we focus on the short end of the yield curve, since it is likely that significant market segmentation exists between short-term and long-term bond markets.