Marvin Goodfriend

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Research Papers in Economics

FEDERAL RESERVE BANK OF ST. LOUIS REVIEW JULY/AUGUST 2008 443
Commentary
Marvin Goodfriend
it does today. The main difference is that today we
speak of central bank “transparency” or “policy
guidance” rather than central bank “secrecy.” I
remember thinking that it was unlikely that central
bank secrecy would ever be debated openly, and
if it ever were, then I thought the case for trans-
parency would quickly win the day. I wasn’t quite
correct on either outcome.
In any case, it is useful to recall how far we’ve
come. For the most part, central banks have moved
away from secrecy toward transparency, partly
by being more explicit about longer-run inflation
objectives and partly by communicating short-
term policy concerns and intentions more explic-
itly. Few would now claim that secrecy is a tool
of monetary policy. Quite the contrary, communi-
cation is today widely recognized to play a central
role in monetary policy. That said, we have come
to the point where even those who favor trans-
parency in principle worry that excessive forward
guidance on monetary policy might be counter-
productive. This is the thrust of the concern
expressed by Bill that motivates Carl Walsh’s
(2008) paper.
The balance of my remarks addresses the
limits of forward guidance by drawing a distinc-
tion between two dimensions of information
policy: (i) transparency with regard to a long-run
inflation objective and (ii) discretionary announce-
ments used by central banks to substitute for
transparency about a long-run inflation objective.
Transparency and communication help to
implement interest rate policy in two ways—
B
ack in 1984, I was invited by Bill Poole,
then a member of the President’s
Council of Economic Advisors, to
work as a senior staff economist for
money and banking at the Council. When I
arrived at the Old Executive Office Building that
fall, I brought with me an early draft of a paper
on central bank secrecy that I had just finished.
I gave a copy to Bill, who I knew had a long-
standing interest in central bank communications.
I remember his reaction: Bill put the paper in an
envelope, signed it, wrote on it “for my eyes
only,” and had his secretary put it in a safe. How
appropriate, I thought! Later, Bill asked for a
briefing and I described among other things the
substance of the FOMC defense of monetary
policy secrecy in a recently concluded Freedom
of Information Act lawsuit.
My interest in the topic was initiated by a
headline in the American Banker that read
“Secrecy Primary Tool of Monetary Policy.” How
could that be? The assertion seemed at odds with
everything Bill taught us in graduate school at
Brown—that, according to rational expectations
theory, more information should be better than
less. Bill emphasized that private agents have an
incentive to use to their advantage whatever
information they have, whatever its source. I wrote
the paper to explore under what circumstances,
if any, central bank secrecy could be justified.
I would never have predicted that “informa-
tion policy” would have generated so much inter-
est among central bankers or as much research as
Marvin Goodfriend is a professor of economics at the Tepper School of Business, Carnegie Mellon University.
Federal Reserve Bank of St. Louis Review, July/August 2008, 90(4), pp. 443-45.
© 2008, The Federal Reserve Bank of St. Louis. The views expressed in this article are those of the author(s) and do not necessarily reflect the
views of the Federal Reserve System, the Board of Governors, or the regional Federal Reserve Banks. Articles may be reprinted, reproduced,
published, distributed, displayed, and transmitted in their entirety if copyright notice, author name(s), and full citation are included. Abstracts,
synopses, and other derivative works may be made only with prior written permission of the Federal Reserve Bank of St. Louis.first, because a central bank uses a nominal
interest rate policy instrument to manage real
interest rates, and second, because a central bank
uses a short-term interest rate to manage longer-
term rates.
The primary role of transparency and com-
munication must be to convey clearly the central
bank’s long-run inflation objective in order to
anchor inflation expectations firmly, so that a cen-
tral bank can manage short- and longer-term real
interest rates reliably with its nominal interest
rate policy instrument.
The secondary role of communication is to
help exercise leverage over longer-term interest
rates with a short-term interest rate policy instru-
ment. This a central bank can do because finan-
cial markets price longer-term interest rates (up
to a possibly time-varying term premium) as an
average of expected future short rates. To manage
expectations of future short rates, a central bank
must take markets into its confidence by commu-
nicating its intentions based on its forecast of
economic conditions, its structural view of the
economy, and its medium-term objectives for
employment, financial stability, and inflation.
Naturally, central banks are reluctant to reveal
much of their current concerns or intentions
because judgments about such things are neces-
sarily imperfect, tentative, and subject to frequent
revision. And some central banks are reluctant
to announce explicitly their longer-run inflation
objectives too. On the other hand, central banks
recognize that interest rate policy benefits from
transparency and communication, and central
banks are inclined to be evermore revealing of
their thinking in an effort to better manage longer-
term interest rates.
The reluctance of central bankers to take mar-
kets systematically into their confidence creates
a reliance on announcements to convey their con-
cerns about the economy and their intentions for
short-term interest rates. Discretionary announce-
ments employed to guide markets in lieu of sys-
tematic transparency about underlying objectives
and concerns would appear to provide a degree
of flexibility in communication policy. The point
I wish to make, however, is that it is an illusion
to think that discretionary announcements can
substitute reliably for systematic strategic trans-
parency. Inevitably, the public will find it hard to
interpret announcements made without strategic
guidance and, therefore, a central bank will find
it hard to predict the public’s reaction to such
announcements.
My point is nothing more than to apply
rational expectations reasoning, made famous by
Robert Lucas, to announcements. It is difficult
for a central bank to predict how either a policy
action or a discretionary announcement will be
interpreted by markets when undertaken with
insufficient strategic guidance, that is, when either
is undertaken independently of a policy rule.
The Federal Reserve’s experience in May and
June 2003 is a case in point. The Fed famously
accompanied a cut in its federal funds rate target
at the May 2003 FOMC meeting with a surprise
announcement that significant further disinflation
would be “unwelcome.” The statement was
intended to alert the market to the fact that the
Fed would act to deter deflation. The Fed was
taken by surprise by what it considered an over-
reaction in the media and markets to its concern
for deflation. The Fed rectified matters by drop-
ping the federal funds rate by only 25 basis points
at the June FOMC meeting instead of the expected
50 basis points.
The market reaction to the surprise May 2003
FOMC announcement was excessive relative to
what the Fed expected, but it could have been
just as easily insufficient relative to what the Fed
intended. Either way, such misunderstandings
are potentially costly for the implementation of
interest rate policy because they whipsaw markets,
create confusion, and weaken a central bank’s
ability to manage interest rates. Failing to convey
a monetary policy message accurately in the first
place can produce an extended period of policy-
induced volatility as the mutual understanding
between markets and the central bank on interest
rate policy is gradually and painfully restored.
Arguably, the confusion in 2003 could have
been avoided if an explicit numerical lower
bound on the Fed’s tolerance range for core per-
sonal consumption expenditures inflation had
been in place. Markets would have been prepared
for interest rate actions the Fed would take as
Goodfriend
444 JULY/AUGUST 2008 FEDERAL RESERVE BANK OF ST. LOUIS REVIEWinflation neared the 1 percent lower bound on its
tolerance range. And longer-term interest rates
would have drifted down as inflation drifted
lower in early 2003 in anticipation of the Fed’s
reaction. In that context, announcements could
have reinforced reliably the Fed’s concern about
further disinflation and the credibility of its
commitment to prevent inflation from falling
below 1 percent.
In conclusion, and returning to Bill Poole’s
concern about excessive forward guidance, we
can say this: Forward guidance on interest rate
policy is likely to be most effective when it rein-
forces a well-articulated monetary policy strategy
anchored by an explicit numerical long-run infla-
tion target. Otherwise, forward guidance should
be undertaken with care and only with good rea-
son given that discretionary announcements are
difficult if not impossible to calibrate consistently
to achieve their intended effect.
REFERENCE
Walsh, Carl E. “Announcements and the Role of
Policy Guidance.” Federal Reserve Bank of St. Louis
Review, July/August 2008, 90(4), pp. 421-42.
Goodfriend
FEDERAL RESERVE BANK OF ST. LOUIS REVIEW JULY/AUGUST 2008 445446 JULY/AUGUST 2008 FEDERAL RESERVE BANK OF ST. LOUIS REVIEW

Announcements and the Role of Policy Guidance.” Federal Reserve Bank of St. Louis Review,

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