Transparency of Monetary Policy and Division of Roles between Governments and Central Banks

YASHIRO Naomitsu
Consulting Fellow, RIETI

Clear Policy Objectives as the Essence of Transparency in Monetary Policy

Clarity in central bank policy objectives is an essential condition for ensuring the transparency of monetary policy. Most of the recent criticism directed to the Bank of Japan (BOJ) boils down to underlying discontent with the lack of clarity regarding its policy objectives. Central banks in developed countries usually attempt to ensure high transparency in their monetary policy by presenting straightforward and sometimes measurable policy objectives, and explain their management stances mainly in the context of such objectives. Inflation targeting is an extreme case whereby committing to achieve a specific level of inflation rate, the central bank explains its monetary policy operations almost solely from the standpoint of achieving such inflation targets. This greatly helps the market participants to understand the central bank's policy stance and also to forecast its future policies.

Article 2 of the Bank of Japan Law stipulates that the BOJ's monetary policy must be "aimed at, through the pursuit of price stability, contributing to the sound development of the national economy." On the other hand, the Japanese government's Basic Policies for Economic and Fiscal Management and Structural Reform 2007 states that the government and the BOJ are to share the perspectives of macroeconomic policy such as: 1) realization of private sector-led growth, 2) realization of price stability, 3) policy operation that is consistent with medium-term goals, 4) improving transparency and responsibility. However, these statements are fairly qualitative and do not provide market participants with useful information for understanding the BOJ's modus operandi.

In order to increase the transparency of monetary policy, the BOJ indicated in March 2006, a consumer price index (CPI) inflation rate of 0%-2% (with a median value of 1%) as the level of inflation that each monetary policy board member understands as the "medium- to long-term price stability." However, the nature of these numeric values is quite elusive as they are neither intended to be the BOJ's policy objective nor its definition of price stability, like the one presented by the European Central Bank. Accordingly, these numbers have not been treated as an important factor in determining monetary policy in the BOJ's monthly monetary policy meetings. In practice, the BOJ's monetary policy board bases decisions on its so-called two pillars - comprehensive evaluation of price and economic conditions, and examination of risk factors that may affect these conditions. However, the board's reasoning based on such evaluation is fairly qualitative, and not sufficiently understood by market participants.

Policy Objectives and Mandates of Central Banks

Whether or not the BOJ should introduce some form of inflation target remains highly debatable. Central banks are assigned policy goals in different ways. In the United Kingdom, known for having one of the most explicit inflation targeting regimes, the Chancellor of the Exchequer, in his Remit Letter to the governor of the Bank of England (BOE), explicitly sets a target inflation rate that must be realized by the central bank. Furthermore, the priorities of monetary policy objectives are clearly established in the same Remit Letter; the BOE must first achieve price stability, only then should it be cooperating with the government in achieving other goals such as maximizing employment. Therefore, the BOE's pursuit of the target inflation rate as its primary policy objective is totally consistent with what the UK government expects of monetary policy. In contrast, the Federal Reserve Board (FRB) is to pursue "full employment and stable prices," which are referred to as a "dual mandate" with no order of priority between full employment and price stability. In the real world, the FRB is always facing the potential risk of being criticized by the U.S. Congress if it prioritizes price stability over economic performance and employment. It therefore has to seek a delicate balance in order to prevent political intervention. This is probably one of the reasons why the FRB has not yet introduced an explicit statement about its thinking regarding a desirable inflation rate.

As for the BOJ, during the course of the 1998 revision of the Bank of Japan Law, which established monetary policy independence, the Financial System Research Council, the Ministry of Finance's task force which drafted the new BOJ Law, submitted a document titled "The Reasons for the Revisions of the BOJ Law". In this document, the following paragraphs were included in the chapter titled "Basic Principles for Currency and Monetary Control":

"The most important goal of the BOJ is to ensure 'price stability.' In doing so, the BOJ's monetary policy operations must be geared, in principle, to contribute to the 'sound development of national economy' through promoting price stability.

Provided, however, that it is not enough for the BOJ to focus solely on price stability. Instead, the BOJ, while pursuing price stability as its basic goal, is also required to implement flexible and clear monetary policy so as to contribute to the sound development of national economy. . . .

Furthermore, as shown by past experience, even when the general price level remains stable, a sharp rise or fall in asset prices - such as land and share prices - may occur and has a serious impact on national economy. Therefore, the BOJ needs to pay attention to changes in asset prices."

This description reveals that the BOJ, when given mandate on its monetary policy, is expected by the Japanese government to conduct its policy based on a comprehensive perspective including sustainable economic growth and asset price stability, instead of the sole pursuit of price stability. It is possible that this underlying spirit of the revised BOJ Law is what provides the BOJ a rationale for its comprehensive evaluation and its zealous emphasis on flexibility of policy operations.

Need for Clearer Redefinition of Monetary Policy Objectives

However, it is very difficult to explain the policy decisions made through such comprehensive judgment to the public in a concrete and transparent way. Although the FRB has been successful in maintaining transparency through comprehensive explanation, such success was supported by former Chairman Alan Greenspan's outstanding ability to communicate with the market, as well as the market's strong confidence in the FRB's monetary policy which realized steady economic growth over the past 15 years.

A clearer definition of a desirable inflation rate and commitment to its realization would help the BOJ to enhance substantial transparency in its monetary policies. However, due to the background previously discussed, there are some issues that need to be sorted out. First and foremost, monetary policy objectives must be clearly redefined and prioritized through discussions between the BOJ and the Japanese government in an open arena such as the Council on Economic and Fiscal Policy. The redefined goals and priorities among them must be then be explicitly shared by both parties. Within this process, it will be necessary to clarify the scope of the BOJ's independence over monetary policy, which is currently somewhat ambiguous. In the UK, where the BOE is granted a high degree of independence, the power to set a target inflation rate rests solely with the Chancellor of the Exchequer.

Clarifying the objectives of monetary policy also means implicitly clarifying the scope of the government's responsibility in macroeconomic policy. For instance, if price stability is defined as the BOJ's primary policy goal, it will bear full responsibility for bringing the economy out of persisting deflation and achieving the desired inflation rate. The government, at the same time, will be primarily responsible for realizing sustainable economic growth and fiscal consolidation. Establishing a regime where government and the central bank assume and are held accountable for their respective responsibilities, without using each other as a scapegoat, is a crucial prerequisite for realizing highly transparent monetary policy.

June 5, 2007

June 5, 2007