Complete 2008 Annual Report - Federal Reserve Bank of Philadelphia

Principles of Sound Central Banking
by Charles I. Plosser
By any measure, 2008 was an extraordinary
year. The economic turmoil that began
in housing two years ago swelled into a
financial tsunami, which roiled the economy over
the course of the year. That turmoil has not been
confined to the U.S. Slowing economic growth
and the deepening credit crisis have affected the
global economy and prompted historic actions by
policymakers in the U.S. and around the world.
The crisis has led to fundamental changes in the
financial landscape, prompting debates about the
central bank’s roles and responsibilities and the
appropriate approach to conducting policy.
In this year’s annual report essay, I want to focus
attention on some of the principles that I believe
make for sound and effective central banking.
Relying on sound principles to guide policymaking
is always useful. But it is particularly important
and helpful in times of crisis, when the temptation
is to abandon all guiding principles and simply
react to the daily challenges based on what seems
expedient at the time. I believe that adhering to
these principles can enhance the effectiveness of
monetary policy in these challenging times and
can provide insights into how the central bank can
promote greater financial stability.
One of the most significant developments in economic
theory during the last quarter of the 20th
century was the recognition of the importance of
expectations in understanding economic behavior.
Expectations about the future play an important
role in the economic decisions of both households
and businesses. This is particularly evident in
financial markets, where expectations about the
future play a role not only in investment decisions
but also in the valuation of securities. Of course,
the public’s expectations about future actions by
policymakers are also important. Will Congress
raise or lower taxes in the future? Will the Federal
Reserve ensure that inflation remains low and stable?
Expectations about these future policy actions
influence the decisions by households and firms
today. Moreover, actions taken by policymakers
today help inform the public about the likelihood
of future policy actions. Thus, policymakers must
make decisions with the understanding that those
decisions may affect the public’s expectations
about future decisions — which, in turn, will affect
the choices market participants make today.
The recognition of the important role played by
expectations leads me to focus on four main principles
of sound central banking. These four principles
are based on lessons learned from both the
theory and the practice of monetary policy. 1 They
include:
Clear Objectives.
1
Policymakers should set clear and
explicit objectives. These objectives must be
realistic and feasible and not just what
might be desirable.
2
3
4
Commitment to
Systematic Policy.
Policymakers must credibly commit to
conducting policy in a systematic — that is,
mostly predictable — way over time, even
when it seems expedient to do otherwise.
Transparency.
Policymakers must be as transparent as
possible in communicating their policies and
actions to the public.
Independence.
Experience has shown that central banks
operating with a great deal of independence
from short-term political pressures deliver
better outcomes.
6 2008 Annual Report www.philadelphiafed.org