Tuesday, February 21, 2012

Central Bank Communication and Financial Stability

Central Banks across the world are racing to go transparent. In United States, the Federal Reserve has raised transparency to new levels by publishing the long-term policy rate forecast and the next rate hike expectations of the individual members of the Federal Open Market Committee (FOMC). The Reserve Bank of India too has not remained unaffected by this trend as its minutes now reveal the individual opinions of its Monetary Policy Committee members.

The argument behind this transparency is that it minimizes information asymmetry and helps shape policy expectations among all market participants more effectively. However, it is far from certain that such transparency is beneficial in the long-term or any more efficient than the current strategy of relative opacity.

For example, in the instant case of the Fed, the longer-term forecasts of the individual members, albeit appropriately qualified, helps bake in expectations of longer-term policy direction among market participants. Though qualified with assumptions and conditions, this fine print is most likely to be overlooked, especially when there is a sustained period of upswing in various growth indicators. As the actions of Alan Greenspan and Co. over the first half of the past decade shows, the members are themselves likely to be blinded to the various cognitive biases that influence their decisions when the economy is either doing well or badly.

The resultant "irrational exuberance" is certain to bias the decisions of a large number of market participants. In these circumstances, the longer-term forecasts act as pro-cyclical amplifiers. In the absence of such forecasts, the market participants would atleast have been that less certain about the economic trends. And given the formidable reputation that central banks have assiduously built-up over the past few years, these forecasts are likely to carry much greater punch than other sources of information.

Therefore, such transparency enhancing forecast publications, tend to make the market participants lean more towards the wind than would have been the case in their absence. Perversely enough, a dose of uncertainty may have diminished the "irrational exuberance" and herd mentality and made market participants more guarded in their economic decisions. In simple terms, instead of improving market efficiency, the reduction of information asymmetry has the potential to lower market stability.

Update 1 (24/2/2012)

It appears that the Fed's push to reduce frictions in one area is complemented by increased frictions in other areas. Simon Johnson detects a very clear bias in the meetings held by the Fed officials on the Dodd Frank legislation,

Just on the Volcker Rule — the provision in Dodd-Frank to limit proprietary trading and other high-risk activities by megabanks — Fed board members and staff members apparently met with JPMorgan Chase 16 times, Bank of America 10 times, Goldman Sachs nine times, Barclays seven times and Morgan Stanley seven times...

Based on what is in the public domain on the Fed’s Web site, my assessment is that people opposed to sensible financial reform — including but not limited to the Volcker Rule — have had much more access to top Federal Reserve officials than people who support such reforms. More generally, it looks to me as though, even by the most generous (to the Fed) account, meetings with opponents of reform outnumber meetings with supporters of reform about 10 to 1.

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