Transparency in Central Banks: An

Analysis
2939 words (12 pages) Essay in Banking

07/05/18

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Introduction

The origin of central banking system can be traced back to 1694 when the Bank of England
came into being as the first ever central bank. The bank was established to help King
William III out of his government’s financial crisis but it did not behave as a lender of last
resort until much later (See Lovell, 1957)1.

Central banking has undergone a remarkable change during the last decade. The new
paradigm in monetary policy appears to be central bank self-governing and transparent.

First of all let’s see what central bank and transparency means, a central bank is a
Government agency that performs a number of key functions: (1) central bank is the only
bank which has the authority to issue currency on behalf of its nation; (2) central bank has
authority to increase and decrease the supply of credit in the economy which controls the
interest rates; (3) manages the external value of its currency in the foreign exchange
markets; (4) central bank holds a percentage of deposits as reserves of other banks and
other central banks so as to reduce the risk of banks overextending themselves and
suffering from bank runs, (5) acts as Fiscal Agent for the central government, when the
government sells new issues of securities to finance its operations; and (6) The central bank
also plays a vital role of reserving the nation’s emergency funds, and it is because of this
the central bank is called “lender of last resort”.

Transparency in the physically meaning, transmitting light, in the conceptually meaning,

clarity, in the economically meaning, symmetric information, and in the practically
meaning, openness, honesty, clarity, common understanding2. We can say that central bank
is a combination all these that is, it openly correspond or communicates important and
necessary information to the investors, shareholders and the public in short “absence of
asymmetric information between central bank and other economic agents”. Therefore a
central bank is said to be transparent when there is less or no information asymmetry.
Moreover a central bank is said to be transparent if its actions are easily identified, its
policies are readily understood, and its statements are honest or true.

“A central bank is transparent when it provides at all times sufficient information for the
public to understand the policy regime, to check whether the bank’s actions match the
regime and to pass judgment on its performance.”3

Over the past years, financial institutions have tried to implement various strategies to
increase its transparency. One of the important strategies among these is, disclosure of
information in published accounts has been prominent even though it was present but less
prominent. A great amount of focus was given towards economic policymaking so as to
become more transparent – particularly with respect to monetary policy, inflation targeting
a very transparent monetary policy regime was adopted by and a number of central banks,
including Sweden’s Riksbank and Britain’s Bank of England. Yet, few other countries like
the United States have not yet subscribed to inflation targeting, but the Fed has also become
much more transparent about its policymaking and operations over the past 15 years. The
New Basel Accord (Pillar 3) has introduced a number of disclosure requirements that aim
to improve the market’s ability to assess a bank’s risk and value.

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The drift towards central bank being more transparent can be easily seen in our day to day
life by casual observation. Some of the prominent examples of various central banks who
have given great importance to becoming transparent are the central banks of New Zealand,
Canada, the United Kingdom and Sweden. These few nations have adopted a framework of
‘inflation targeting’ from the early 1990s itself, which is characterized by an explicit
inflation target and the publication of inflation forecasts.4 Many others countries have even
started to give importance to having adopted greater openness as well, even if it’s not in the
form of inflation targeting or inflation forecasting. The few other central banks which have
adopted this includes central banks in emerging markets like Brazil, the recently founded
European Central Bank (ECB), and even the well established central banks like those of the
United States, Japan and Switzerland.

Literature Review

“Consider the legions of economists whose sole function it is to interpret U.S. Federal
Reserve Chairman Alan Greenspan’s every twist and turn of phrase so as to divine which
way the monetary winds are blowing.”

– Caroline A. Baum, The Last Word p.645

From the above phrase, two important points can be looked upon; one is that by trying to
assume what the actions of monitory policy will be the resources are used up. The other is
that statements are being made by the central bank that might yield some insight into its
future plans, but the messages are not typically transparent.

The economic policy outcome can easily be identified to a great extend by the increased
transparency on central bank through various channels. It cannot be assumed that all the
aspects points out the same way. Moreover, central bank transparency cannot be universally
defined in all aspects6. The concept of transparency differs from authors to author in
various ways, some may focus mainly on the decision-making process, while some others
may focus on various other aspects like models, preferences, and even more some may look
into the knowledge about the shocks hitting the economy, or the implementation of policy
decisions.7

The private information’s about the central bank’s objectives or intentions can be easily
assumed from the models derived by Faust and Svensson (2000, 2001), Jensen (2000),
Geraats (2001a), and Tarkka and Mayes (1999). The model by these eminent economist
states that, “transparency is modeled as the degree of asymmetric information about control
errors (Faust and Svensson (2001) and Jensen (2000)) or (anticipated) economic shocks
reflected in the policy instrument” (Cukierman (2000a,b) and Tarkka and Mayes (1999)).

Kuttner and Posen (2000) yet another eminent economists explains about the reduction of
exchange rate volatility when there was a shift in the Federal Reserve’s and the Bank of
Japan’s degrees of transparency.8 In addition to this, political pressures, increased
accountability, facilitation of fiscal and monetary policy co-ordination, and improved
internal organization of central bank analysis is yet another arguments in favor of
transparency in monetary policy.9

Analytically, the three different regimes of transparency that is the least transparent, highly
transparent and the extreme transparent are being distinguished by Faust and Svensson
(2001). In the first regime, that is the least transparent, neither the employment goals nor
the intentions of the central bank can be seen by the public. Inflation intentions of the
central bank can be easily observed by using the second regime that is highly transparent.
As a result of this increased transparency in inflation intentions there arises a lower
inflation rate because the sensitivity of a central bank is increased which in-turn increases
the reputation to its actions, making it more costly for the central bank to pursue a high-
inflation policy. In the extreme transparency regime, that is the third according to the
author, both the intentions of the central bank as well as the employment goals can be seen.
The central banks reputation as well as its actions are no longer conveyed about the
inflation bias. Higher inflation, inflation volatility and unemployment variability can be
reached at as a result of inflationary bias.10

Yet another similar structure to Faust and Svensson (2001) was adopted by Jensen (2000)
assuming that central bank is informed privately about its output target and that public’s
capacity to assume the inflation control error is greater. On comparison with Faust and
Svensson (2001), who’s main focus was on the future credibility effect of central bank,
while Jensen (2000) focus was towards the marginal cost of inflation within the current
period with the help of new Keynesian elements (staggered price-setting and monopolistic
competition). Due to this increase in the transparency, there was an increase in the
discipline and credibility to the reputational costs of deviations from the inflation target.

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According to some of the eminent economist, transparency is not only the tool used for
independent central banks to be held accountable, but it is often argued that the economic
point of view too can be desirable from it. The effect of central bank being transparent is
being immensely discussed by various policymakers and researchers. Although most of the
literature tends to favor transparency of central bank, it’s not the case, the debate still
continuous whether or not central bank should be transparent or not. Most of the practical
and observed research concludes that the transparency maintained by central bank
previously were desirable from an economic point of view.

An important question to be asked is, whether central banks pushing toward more
disclosure of information are beneficial or not. Indeed, there are a number of good reasons
to it. First, it can be argued that banks from the early time itself are opaque institutions, and
increase in disclosure might not change this opaqueness.

Second of all, transparency might not necessarily be reached at by just simply increasing
the quantitative disclosures. In the words of Federal Reserve Chairman Alan Greenspan: “A
more complex question is whether greater volume of information has led to comparable
improvements in transparency of firms. In the minds of some, public disclosure and
transparency are interchangeable. But they are not. Transparency challenges market
participants not only to provide information but also to place that information into a context
that makes it meaningful” (Greenspan 2003, p. 7).11

Third, disclosure is costly. Clearly, “requiring disclosure of information imposes a cost on

banks, as on any firm, and this cost must be offset by resulting benefits for it to be
justified” (Schaffer 1995, p. 26).12 Publishing information and producing information are
some of the direct cost involved in the cost of disclosure, even though these are the direct
cost involved, when a bank publishes its information in the financial market, there arises a
threat of its competitors exploiting the information which might result in indirect cost.

Cukierman and Meltzer (1986) eminent economists developed concept of central bank
transparency13. Bankers, mainly the central banks use of monitory policy control was in
great fault or imperfect in order to hide their intentions. In other words, the absence of
transparency with control error was evident to meet the central banks objective, at least
possible reputation cost. More recently, with the setup from the Cukierman and Meltzer,
Faust and Svensson (1999) was able to differentiate more between transparency and control
error. Central bank chose the pair that maximizes it objective and it was to be opaque.

There are still some argument that incomplete transparency is optimal, as by being
incomplete optimal, the central bank’s ability to control inflation has to be balanced against
the private sectors wish to see price stability, employment and output.(see for example
Faust and Svensson, 2001 or Jensen, 2000). Others argue that for operational reasons, it is
important to have certain restrictions on transparency. The main idea behind this is to
differentiate between the ‘need to know’ (see Eijffinger and Hoeberichts, 2002) and ‘the
need to understand’ factor (Issing, 1999) and to reinforce the Bank’s credibility.

There are yet more evidence of central bank being transparent and central bank
transparency being one of the important feature of monetary policy, which is been recorded
in one of the most comprehensive survey being conducted till date on monitory policy of
central bank. It’s been recorded in the 1998 survey of 94 central banks by Fry, Julius,
Mahadeva, Roger and Sterne (2000). This survey discloses that about 74% of central banks
consider transparency as a vital or very important component of their monetary policy
framework, only exceeded by central bank independence and the maintenance of low
inflation expectations (with 83% and 82%, respectively; Fry et al. (2000, p. 135)).
Subsequently, the relevance of transparency have only increased when certain changes are
being done by central bank.

Analysis

According to one of the famous journalist, Caroline A. Baum, she says that from the phrase
given by Alan Greenspan, the U.S. Federal Reserve chairman, the resources are being used
up at the same time the statements made by the central bank are far too less transparent.
What it means to say is that the central bank should be more transparent enough so that its
monitory policy at the same time its future plans can be easily understood by even a layman
who might have little knowledge about the norms and policies of the central bank.

By central bank being more transparent, the economic policy outcome can be know to a
certain extend through various means, but it cannot be said that by central bank being
transparent, all the aspects related to it can be easily viewed at. The concept of transparency
differs from person to person, while so concentrate on the decision making process, others
may look into the fact of policy making etc. Therefore it can be said that there is no
universal meaning to central bank and varies from person to person and country to country.
For example the transparency of central bank in India might not be same as the
transparency in England besides taking into some common facts.

According to some of the eminent economist, central bank should have an optimal degree
of transparency mainly for the monitory policy, but on analysing the facts by few others
about whether central bank should be more transparent or not, two aspects can be taken into
account, one is the uncertainty and the other is information overload. If central banks
becomes more transparent, it could lead to uncertainty, that is, when lots of information are
provided to the public, they tend to look at the complexity of monitory policy making and
the uncertainly around it which might not be as complex as it seems to be. The second is
the high degree of information overload or confusion. If large amount of information is
being disclosed to the public, there is a high risk of information getting overloaded or
confused. Therefore analyst say central bank should have an optimal transparency.

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Kuttner and Posen states that when central bank becomes more transparent, there is less
volatility in the exchange rate. Yet other important factors supporting central bank
transparency are the fiscal and monitory policy coordination, political pressures,
accountability etc.

According to Faust and Sevensson, transparency can be segregated into three divisions, the
least transparent where in the public does not know about the employment goals as well as
the intentions, this has also been stated by Cukierman and Meltzer. In the second division,
that is if central bank in highly transparent, the inflation intention can atleast be know by
the public and finally in the case of extreme transparency, both the intentions as well as the
employment goals can be seen.

It can seen that Jensen another eminent economist has also taken up a similar structure to
that of Faust and Svensson where the difference is that while Faust and Svensson focus on
the future credibility effect of central bank, Jensen’s focus was on the marginal cost of
inflation.

Some argue that by increasing its disclosure doesn’t completely increase the transparency,
to support this economist states that banks have been an opaque institution from the past
itself. Greenspan says that transparency is not reached at by just simply giving quantitative
disclosure; it should be both quantitative and at the same time should be relevant and
meaningful. Moreover disclosure is costly, that is when central bank publishes information,
it incur cost both direct and indirect.

Some other economists (Eijffinger and Hoeberichts and Issing) state that central bank
should transparent in such a way that the information which should be known to the public
should be disclosed rather than disclosing all the information.

Conclusion

The dispute whether central bank should be more transparent or not is still being discussed
immensely by various researchers and policymakers. Most of the economist favour central
bank being transparent, as well as according to the study done, it can be understood that
central bank being transparent will give a clear cut information to the public regarding the
various monitory policies, its decision process as well as its goals and intentions. Moreover
by central bank being transparent, it reduces the macroeconomic uncertainty like the
interest rates, inflation etc, promotes financial stability and mainly helps the central bank to
stand out from the various other banks that is being independent.

References

1. Petra M. Geraats, “Central Bank Transparency”, (2007).

2. Cruijsen and Eijffinger, “Actual versus perceived central bank transparency: The
case of the European central Bank,” (2007).
3. Ursel Baumann and Erlend Nier, “Disclosure, Volatility, and Transparency: An
Empirical Investigation into the Value of Bank Disclosure”, (2004).
4. Petra M. Geraats, “Central Bank Transparency”, (2002).
5. Joseph H. Haslag, “On Fed Watching and Central Bank Transparency,” (2001).
6. Georgios Chortareas, David Stasavage and Gabriel Sterne, “Does it pay to be
transparent? International evidence from central bank forecasts,” (2001).
7. ICMB, “Why do Central Banks Need to Talk”, (2001).
8. Gary Gorton and Lixin Huang, “Banking Panics and the Origin of Central
Banking”, (2001).

Websites

1. http://www.blurtit.com/
2. http://www.answers.com/
3. http://papers.ssrn.com/
4. http://en.wikipedia.org/