MARKET UNCERTAINTY, TRANSPARENCY AND FUTRE MONETARY POLICY

1. MARKET UNCERTAINTY, TRANSPARENCY AND FUTRE MONETARY POLICY Marc Hayford and A.G. Malliaris Loyola University Chicago WEAI Conference, June 29-July 3, 2007 Seattle

2. Purpose • Identify sources of uncertainty • Discuss the role of Central Bank transparency • Evaluate the role of Fed transparency

3. Uncertainty • Two sources of uncertainty • Statistical Uncertainty • Knightian Uncertainty

4. Sources of Uncertainty • Uncertain economic data • Uncertain forecasts • Uncertainty in model building • Uncertain policy effects • Global dimensions of uncertainty • Other

5. Degrees of Uncertainty • Conflicting signals about inflation • Conflicting signals about economic growth • Asset bubbles and bursting of bubbles • Economic shocks • Non-economic shocks

6. Central Bank Transparency Key Question: How should the Fed exercise its responsibilities in a democratic society guided by institutions of freedom and accountability?

7. Central Bank Transparency • Academic economists and policy makers agree that the Fed’s accountability for its actions to preserve low inflation and promote economic growth is best expressed in its degree of transparency

8. Definitions • Transparency means the lack of asymmetric information between monetary policy makers and market participants. • This is equivalent to saying that transparency describes the presence of symmetry of information between the two. • Lack of transparency leads to greater uncertainty. • Transparency, even in the absolute sense, does not lead to certainty but only to reduction in uncertainty.

9. Benefits of Transparency • Transparency limits the ability of policy makers to manipulate policy for political gains. • The more transparent the Federal Reserve is in its monetary policy, the better the relationship will be between the monetary policy makers and Congress. • Transparency is one of the theoretical conditions required for a free market to be efficient.

10. William Poole’s (2005) brief history of transparency • The first central bank to initiate a move towards more transparent monetary policy was the Reserve Bank of New Zealand in 1990. • Central banks of Canada, the U.K., and Sweden followed suit. These central banks became known as “inflation targeters”. • Currently, 28 central banks around the world follow this new transparent approach regarding policy objectives as well as the policy instruments.

11. Fed Transparency • 1967 :Freedom of Information Act; Memorandum of Discussion and Record of Policy Action. • 1979 to 1993: Minutes of FOMC. • February 1994: FOMC meeting signals changes in Fed funds. • July 1995: FOMC meeting the Fed began to explicitly state the Fed funds target. • May 1999: FOMC includes reasoning.

12. Empirical Work • T-bills from the Survey of Professional Forecasters http://www.phil.frb.org/econ/spf/index.html • Descriptive statistics • Single equation regressions • Structural vector autoregressions

17. Dependent variable:

19. Results of Single Equation Regression • The introduction of transparency resulted in a reduction of the average forecast dispersion by about -20% to -50% of the sample mean. • The reduction in the forecast dispersion is approximately -20% to -30% for the 2 quarter ahead.

20. Results • Our estimates suggest that controlling for financial/political crisis and the absolute value of the change in the Federal funds rate, the changes in monetary policy transparency introduced in 1994 and 1995 resulted in a large reduction in uncertainty about future monetary policy 1 to 3 quarters into the future.

21. VAR Results • Overall the VAR results suggest that shocks to inflation, the unemployment rate and the Federal funds rate have a temporary impact on forecast dispersions and hence uncertainty about future monetary policy. This is consistent with the Fed’s monetary policy transparency being successful in credibly communicating the future stance of monetary policy as well as the ultimate goals of monetary policy.