Central Bank Secrecy, Interest Rates, and Monetary Control
Thomas F. Cosimano and John B. Van Huyck
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Abstract: This paper provides a rationale for secrecy about a central bank's current monetary aggregate objectives in a dynamic rational expectations model of the federal funds and deposit market. Secrecy about the current reserve target forces commercial banks to solve a multivariate signal extraction problem in which they use the current federal funds rate and the current deposit rate to estimate both current and future reserve targets. The signal extraction problem results in the federal funds rate being less sensitive to the current level of reserves, and, hence, secrecy lowers the marginal interest rate cost of moving towards the central bank's reserve target. Consequently, the central bank prefers secrecy to disclosure. In this analysis, the Trading Desk values secrecy because it reduces the influence of its monetary control policy on interest rates. A standard result is that secrecy reduces the predictability of interest rates, which undoubtedly makes the private sector worse off. However, a second more subtle--and overlooked--effect of secrecy is that changing the information regime changes the covariance structure of the economy. In general, it is not possible to order the value of commercial banks under the alternative information regimes. However, for some reasonable parameter values both the central bank and commercial banks prefer secrecy to disclosure of the current monetary aggregate objective.
Acknowledgments: Ron Balvers, Michael Dotsey, Burkhard Drees, Raymond Lombra, Carlos Pinerua, Richard Sheehan, Carl Walsh and seminar participants at the NBER/FMME 1988 Summer Institute, the 1988 meetings of the Southern Economic Association, Indiana University, Texas A&M University, and the Finance department of the University of Notre Dame made helpful comments on an earlier version of this paper. Lisa Narbut provided research assistance.
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Central banks are notoriously secretive not only about the policy making process but also about the actual policy adopted. For example, the Federal Open Market Committee of the Federal Reserve System (hereafter denoted FOMC) does not keep minutes of its policy meetings and does not disclose the Domestic Policy Directive--the adopted policy--until the directive is no longer current. While it is easy to rationalize secrecy about the policy making process, intuitively, secrecy about the adopted policy is puzzling since the uncertainty created might be expected to inhibit a central bank's ability to achieve the adopted policy.
The FOMC provided several arguments for its policy of non-disclosure in Merrill v. FOMC, one of which was the "inappropriate market reaction" defense. The "inappropriate market reaction" defense argues that disclosure of the current policy would cause markets to move interest rates in a manner contrary to the central bank's objectives. Goodfriend (1986,p.72) points out that the "inappropriate market reaction" defense is puzzling. Given efficient markets, "one would like to know how market reaction which moves interest rates in a manner implied by the FOMC's instructions to its Account Manager could be undesirable or contrary to the FOMC intentions."
This paper uses a choice-theoretic framework to formally examine the "inappropriate market reaction" defense of central bank secrecy. Specifically, this paper provides a rationale for secrecy about a central bank's current monetary aggregate objectives in a dynamic rational expectations model of the federal funds and deposit market. In the model, secrecy forces commercial banks to solve a multivariate signal extraction problem in which they use the current federal funds rate and the current deposit rate to estimate both the current reserve target and future reserve targets [the reserve targets follow an autoregressive process]. The signal extraction problem results in the federal funds rate being less sensitive to the current level of reserves.
Central bank concern for the level of interest rates can induce it to consistently set total reserves above its current reserve target. Secrecy, by reducing the sensitivity of the interest rate to the current level of reserves, lowers the marginal interest rate cost of moving towards the central bank's reserve target and, hence, lowers the upward bias in total reserves. Consequently, the central bank prefers secrecy to disclosure. In this analysis, the Trading Desk values secrecy because it reduces the influence of its monetary control policy on interest rates.
Conventional wisdom holds that the welfare of commercial banks is lowered by central bank secrecy. The influence of central bank secrecy on the variability and predictability of interest rates is a common object of analysis. A standard result is that secrecy reduces the predictability of interest rates. [1] However, a second more subtle--and overlooked--effect of secrecy is that the information regime changes the covariance structure of the economy.
Given the choice-theoretic framework of this paper, it is possible to examine the conjecture that central bank secrecy lowers the value of commercial banks. In general, it is not possible to order the relative value of commercial banks under the alternative information regimes. The information regime influences the value of commercial banks through two channels. Secrecy motivates the trading desk to supply less reserves on average, which reduces commercial bank profits; But, secrecy increases the covariance of deposits with the spread between the loan rate and the deposit rate, which increases commercial bank profits. The analysis reveals that for reasonable parameter values central bank secrecy can increase the value of commercial banks. Consequently, it is possible that both the central bank and commercial banks prefer secrecy to disclosure of the current monetary aggregate objective.
[ Top | Introduction | References | Footnotes | John's Web ]
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[1] See Dotsey (1987) and Tabellini (1987) on the relation between secrecy and the predictability of interest rates. See Lombra and Struble (1979) for a discussion of the relationship between the predictability of interest rates and the welfare of financial institutions.
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