Central Bank Transparency

With another Federal Reserve policy meeting coming up tomorrow, and another quarter point rate hike baked in the cake, the only real question is about the policy statement accompanying the rate announcement. In particular, there is great anticipation as to whether the magical word 'measured' will be retained or removed, and if it is removed, what will replace it.

Apparently this passes for improved transparency at the Fed.

When viewed against openness from a historical point of view, great strides have been made by the Federal Reserve - compared to some of their contemporaries, transparency lags. This story($) from The Economist prompts a few thoughts about what central bank transparency is and what motivates it.

The end of surprises

It is becoming easier to understand the workings of central banks

NO ONE should have been surprised when, on December 1st, the European Central Bank (ECB) raised euro-area interest rates by a quarter of a percentage point, to 2.25%. The rate increase may be controversial, but it was scarcely unexpected: Jean-Claude Trichet, the ECB's president, had dropped the heaviest of hints far in advance.

In fact, central banks everywhere are becoming easier to read: look at the long, predictable series of rate rises by America's Federal Reserve. It wasn't always so. In pre-euro days, Germany's Bundesbank almost enjoyed taking markets by surprise. And it was only in 1994 that the Fed started saying publicly whether it had changed rates at all. Until then, it was up to the markets to work out what, if anything, had happened.

Now most central banks swear by “transparency”. This covers more than just preparing the ground for interest-rate moves; everything from setting out policy objectives to publishing economic models and forecasts also falls under the term.

However, some are more transparent than others; and different banks are open in different ways. The ECB, for example, does not publish minutes of its rate-setting meetings; the Fed and the Bank of England do. And whereas the British and the euro-zoners have inflation targets, the Fed so far does not.

In a new study, Sylvester Eijffinger, of Tilburg University, and Petra Geraats, of the University of Cambridge, present an index of the transparency of nine central banks—the eight that matter most in foreign-exchange markets, plus New Zealand's, the pioneer of central-bank clarity. Banks can score up to 15 points, three for each of five types of openness: political (eg, whether a central bank has a formal target and whether it is independent); economic (its data, models and forecasts); procedural (strategy and the publication of minutes); policy (how decisions are explained, and whether future changes are indicated); and operational (how clearly banks explain missed targets, and how well they explain economic surprises).

The central banks of New Zealand and Sweden top the table in 2002, with 14 points, followed by the Bank of England, with the ECB and the Fed in the middle of the pack (see chart). Almost all central banks became more open after 1998. Sweden's Riksbank saw the biggest change, adopting an explicit indication of where policy might head next and an annual review of inflation (which it targets) over the past three years. Even ten or 15 years ago, few banks would have scored double figures.

Since 2002, central banks have become more transparent still. The Fed, for instance, has been publishing minutes of its meetings more speedily since the start of this year. Mr Eijffinger says that he expects the trend to continue. Ben Bernanke, the Fed's chairman-designate, favours an explicit inflation target. Mr Eijffinger also believes (and hopes) that the ECB will start publishing minutes, something that it has so far resisted.

At the top of the list is the Bank of New Zealand. Why? One of the reasons is that Bank of New Zealand Governor Alan Bollard seems to be particularly observant and pragmatic - a quality particularly lacking in one rather large, predominantly Anglo Saxon country across the Pacific Ocean with a similar home-equity withdrawal fever.

In recent months, Mr. Bollard has said he is intent on raising interest rates "in a way that really hurts," in order to prevent people from borrowing more money against their homes - to prevent them from digging bigger holes for themselve, as Anglo-Saxons, for some reason, are wont to do. "People need to stop using their homes as a source of cash", Bollard told Radio New Zealand last month, where home prices have continued to rise at double digit rates. "That’s why we will keep making these warnings and if necessary take further action…" The central bank "can increase interest rates and we can do it in a way that really hurts."

Wow! That sound like the U.S. Fed Chairman ... from twenty five years ago.

So what did the Bank of New Zealand do last week? They raised rates to 7.25 percent, and included the following comments in their policy statement:

As emphasised in our September MPS, and again at the October OCR Review, we remain concerned about the tightness of resources and the persistence of inflation pressures. Exporters and other businesses exposed to the very high exchange rate are under considerable pressure and general business sector confidence is falling in the face of declining profit margins. However, overall demand continues to outstrip available capacity. The main driver of the strong demand is household spending, linked to a still-buoyant housing market. Increasing government spending and continued strong business investment are also boosting total demand. The resulting excess demand, reflected in a growing current account deficit, is continuing to fuel inflation.
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Mortgage credit growth and house prices have held up longer than anticipated; we are forecasting these to slow markedly in 2006, but continued strength remains a risk. The current high rates of increase in labour and other business costs present a further risk, particularly if inflation expectations become locked in at current high levels.
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This outlook, combined with the lack of inflation headroom, has led us to increase the OCR today. Whether further tightening is needed will depend on the extent to which housing and demand pressures show signs of moderating over the months ahead. However, we do not yet see any prospect of a policy easing in the foreseeable future.

Included in the 43 page full monetary policy statement is this bit of sound reasoning:

Indications of continuing strength in household spending, including rising house prices and rapid growth in mortgage lending, were an important consideration in our decision in October to increase the OCR to 7 per cent. As the Bank noted several times during October and November, strong household spending is preventing an easing of inflation pressures as well as contributing to a worsening current account deficit. We also noted that the longer adjustments in behaviour and asset prices are deferred, the more disruptive the eventual adjustment process is likely to be.

How unusual for a policy statement to so clearly enunciate what is going on in a country's economy. Compare this to most recent policy statement from the U.S. Federal Reserve, and you get a strikingly different view of a common condition - home equity withdrawal fueling inflation:

Elevated energy prices and hurricane-related disruptions in economic activity have temporarily depressed output and employment. However, monetary policy accommodation, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity that will likely be augmented by planned rebuilding in the hurricane-affected areas. The cumulative rise in energy and other costs has the potential to add to inflation pressures; however, core inflation has been relatively low in recent months and longer-term inflation expectations remain contained.

The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal. With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured. Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.

Nary a mention of home equity withdrawal or consumer spending. With robust productivity growth, relatively low core inflation, and long-term inflation expectations contained, it is natural to wonder why rates are being raised at all.

So, how transparent is the Fed, really?