How Transparency Could Harm You, Me, and the FOMC

Sarah Binder, as usual, provides excellent insights into a difficult political problem in this post discussing the potential political and economic pitfalls of imposing greater transparency on the Federal Open Market Committee (FOMC), which essentially directs the Federal Reserve’s active participation in the economy, thereby having the most direct control over short-term interest rates and, accordingly, day-to-day “monetary policy” in the United States.

The FOMC is a really big deal.  As Binder notes, the importance of the committee accordingly makes both economic and political observers keen to understand and forecast what it will do in the future.  By deciding over the past decade or so to publish more and more detailed data about the views of the FOMC members,[1] the Fed has increased the transparency of the information it receives.

This seems like a good idea, right?

Well, social science theories in both economics and political science acknowledge the importance of whether the FOMC’s behavior is predictable or not.  On the economics side, predictability of monetary policy (at least in terms of its outputs such inflation) is generally perceived to be a good thing, because it allows investors to focus more attention on the “fundamentals” of an asset’s value, as opposed to paying a lot of attention to purely nominal phenomena and/or inefficiently delaying/accelerating investment and consumption decisions.  In other words, while a low, fixed inflation rate is good, variation in the inflation rate is inevitable, and if this variation can be reasonably accurately forecast, this is a “second-best” outcome.

On the political science side of things, a traditional argument for transparency (in addition to the one above) is that it fosters legitimacy and/or public confidence in the Fed, and thereby makes the Fed a more credible “political actor.”  A more technical description of this is that transparency alleviates an adverse selection problem between the Fed and the public.  The Fed knows something that the public/Congress/Presidents want to know, and—in some situations—everyone would be better off if the Fed could somehow just reveal this information to the public/Congress/Presidents.

Solving this kind of problem is very tricky in practice, because a real solution requires that the Fed not be responsible for releasing the information.  And there’s some interesting things in the FOMC structure (it’s composed of multiple, and members with various overlapping terms) and the evolution of the transparency.

Being the contrarian that I am, I wanted to note two arguments against too much transparency.  I don’t think these are strong enough to justify total opacity, of course, but I do believe they’re strong enough to serve as cautionary tales regarding total transparency.

Each of these arguments revolves around an additional potential instantiation of adverse selection.  The first regards the motives of the individual members of the FOMC.  When decision-makers are career-oriented (they want to be reappointed/promoted/rewarded for their ability/performance, etc.), too much transparency about the decision-maker’s actual decision (i.e., votes and personal positions on monetary policy in the FOMC meetings) can induce conformism (or “pooling”) by the agents such that their policy decisions become suboptimally unresponsive.  For example, everybody might start acting as an inflation hawk would so as to increase the perception of their hawkishness (a worry indirectly indicated in Yellen’s comments as discussed by Binder).[2]

The second argument involves the incentives of those that make individual decisions that the Fed observes.  In particular, the Fed (and every regulatory agency) collects lots of data about the behaviors of firms and individuals.  In some cases, if (say) major firms (as the Fed is responsible for regulating) have access to the information that the Fed will ultimately use to make policy, the incentives of these firms to make decisions that are individually suboptimal in order to try and manipulate the Fed’s subsequent decision-making will be exacerbated.  That is, transparency of the Fed’s information can increase the incentives of major banks (and, arguably, even other regulators) to choose their own actions in ways that try to obscure their own private information.  When this happens, you have a double-whammy: (1) the individual firms’ decisions are not optimal and (2) the Fed does not glean as much information about the real state of the economy from the decisions of these firms.

Sean Gailmard and I make this point (coincidentally with an empirical application to Financial Industry Regulatory Authority (FINRA)) in our recent working paper, “Giving Advice vs. Making Decisions: Transparency, Information, and Delegation.”

Conclusion. I definitely don’t know what the “right” policy for the Fed is without further thought.  But the supposition that “increased transparency is unambiguously good” is at odds with at least two theoretical arguments. Accordingly, it might not be nefarious motives that lead policymakers to call for discussion of “how much transparency is too much?”


[1] See this description of the recent evolution of Fed transparency and, for a little historical context, see this report describing the 2007 change.

[2] Note that this argument implies that observing the actions of the decision-maker(s) can be bad, but it does not necessarily imply that observing what happens from those decisions (e.g., the actual inflation rate) can be bad. (Good citations on this point are Prat (2005) (ungated working paper here) and Levy (2007) (ungated working paper here), and my colleague Justin Fox has produced multiple excellent theoretical studies centering on this question (here, here (with Ken Shotts), and here (with Richard Van Weelden)).