Why the Fed should be more opaque

It almost sounds like an overprotective mum's harangue, but a senior official at Moody's is now warning: too much transparency on the part of central banks could prove counterproductive to policy intentions.

Instead, central bankers need to adopt ôa selective use of transparencyö if they want to maximize outcomes stemming from their operations, argues Tony Hughes, MoodyÆs Economy.comÆs director of Asia-Pacific economics. (Moody's Corporation acquired Economy.com for $27 million in November 2005)

He points to Japan and the United States as prime examples of countries who should take cover rather than go streaking with their central bank plans.

In the case of Japan, Hughes argues that the BoJÆs policy of ôquantitative easingö and its eagerness to reveal the extent of its thoughts and actions may actually be undermining the nation's success in ending deflation.

ôBy engaging in actions to boost the short-term cost of capital, the BoJ is effectively dampening demand and thus reducing the likelihood of a near-term end to deflation. Despite better data of late, this is in no way a fait accompli,ö Hughes says. ôInstead, the BoJ should just keep its mouth shut, its hands tied and just say and do nothing.ö

As for the US Fed, Hughes reckons that too much transparency has led to market over-confidence in its ability to fight inflation. He points to the flat yield curve that currently prevails in financial markets. Instead, it would be in the FedÆs interests to ôpull up a shroud around at least some aspects of its operationsö to gain greater control over long-term bond rates, argues Hughes.

ôUltimately, market faith in the FedÆs ability to fight inflation must equate with its actual ability, which is partially determined by its ability to affect long-term yields,ö says Hughes. ôConsequently, if faith rises above ability, as seems to be the case at present, and inflationary shocks hit, then inflation will appear and the Fed will be revealed as `a mere mortalÆ.ö

He reasons that the subsequent return of market scepticism in the Fed would allow it to then push up long-term bond yields as a counter to inflation. It could short-circuit this potential inflationary outbreak by opting to be more opaque in its dealings with markets.

Perhaps mum was right.