Complete 2008 Annual Report - Federal Reserve Bank of Philadelphia

Principles of Sound Central Banking
central bank expects will happen in the economy.
Transparency increases the public’s understanding
of monetary policy, which in turn increases the
credibility and effectiveness of monetary policy.
Financial Stability — Transparency is also important
in communicating the policy and actions that the
central bank takes on financial stability. This is an
important part of reducing the uncertainty and
making the “rules of the game” clear as the central
bank responds to a crisis.
Another reason to ensure clear and transparent
communications when policymakers take extraordinary
actions to ensure financial stability is that
such actions can create moral hazard. Indeed,
the mere act of creating the Fed’s special lending
programs over the course of the past year has created
moral hazard. To the extent that market participants
now feel more comfortable asking for the
central bank’s support when they get into trouble,
they may be inclined to take on more risk than
would otherwise be prudent — thus sowing the
seeds for the next crisis.
Intervening too often or expanding too broadly the
set of institutions that have access to the central
bank’s credit facilities not only creates moral hazard
but also distorts the market mechanism for allocating
credit, thus increasing the probability and
severity of a future financial crisis.
Clarifying the criteria under which we will intervene
in markets or extend credit, including defining
what constitutes the “unusual and exigent”
circumstances that form the legal basis for the
Fed’s nontraditional lending, will be essential if we
are to mitigate the moral hazard we have created
and reduce uncertainty about future actions.
Of course, announcing the central bank’s criteria
in advance does not commit it to act as stated in
every case, but it does raise the costs of deviating
from the criteria. We should be prepared to
stay the course once our policy is set and clearly
communicate the lending policy and the actions
we take in our capacity as lender of last resort.
Ensuring the
4 Independence of the
Central Bank
The fourth principle of sound central banking is
independence. A central bank’s independence
has many dimensions; however, it does not mean
that central bankers or other policymakers should
not be accountable to the public. The importance
of transparency and the communication of clearly
articulated goals as guiding principles are keys to
ensuring the legitimacy of our public institutions.
Monetary Policy – Research has suggested that
countries with more independent central banks
have benefited from lower rates of inflation,
on average, without sacrificing real economic
growth. 11
One of the primary reasons independence is so
essential is that monetary policy works with long
lags. So, central bankers must take a longer-term
view of their policies. This need to take a long-run
view is undoubtedly one of the reasons that more
central banks around the world have been given
greater independence from their nations’ treasury
departments or finance ministries and the political
process. History is replete with examples of the
dangers of central banks being used as an arm of a
country’s fiscal authority. The result is often high
levels of inflation.
Freeing central bankers from the short-term
pressures that inevitably manifest themselves in the
political arena helps monetary policymakers better
balance the short- and long-term factors inherent
in their decisions. This independence, though,
underscores the need for accountability and,
therefore, transparency, which further illustrates
that these four principles are mutually reinforcing.
Financial Stability – Just as we know that
independence leads to more effective monetary
16 2008 Annual Report www.philadelphiafed.org