[L]et me close by addressing a question that often arises about the use of a supervisory stress test, such as those conducted by the Fed, with common scenarios and models. Such a test may create the possibility of, in former Chairman Bernanke's words, a "model monoculture," in which all models are similar and all miss the same key risks. Such a culture could possibly create vulnerabilities in the financial system. At the Fed we try to address this issue, in part, through appropriate disclosure about the supervisory stress test. We have published information about the overall framework employed in various aspects of the supervisory stress test, but not the full details that banks could use to manage to the test. This--making it easier to game the test--is the potential negative consequence of transparency that I alluded to earlier.

What we can do is to do our very best to communicate clearly about our policy, and our expectations, to avoid any type of needless misunderstanding of our policy that could create volatility in the market and potential spillovers as well to emerging markets. And I have been trying to do that now for some time. I've been doing my best to make good on that pledge.

Looking back on the period, the run-up to the financial crisis, I don't think by any means measured pace and the very predictable pace of 25 basis points per meeting explains why we had a financial crisis, but it may have diminished volatility and been a small contributing factor. And the committee will have to think about how to do this. I think many people in the aftermath of that episode think that somewhat less of a mechanical pace would perhaps be better, but this is a matter that we will in due time have to discuss.

The science of monetary policy has not progressed to the point where we can specify the optimal rule for setting monetary policy. The reason is that optimal rules, that is, those that maximize economic welfare, are highly dependent on the particular model from which they are derived, and there is no broad-based consensus for the right model. More relevant is the finding that the optimal rule for one model can produce very bad outcomes in another model. In addition, optimal rules can often be quite complex, thus making them difficult to implement and to communicate to the public. In other words, they may not be very transparent.

However, these limitations to implementing optimal policy rules should not deter us from efforts to adopt a more systematic rule-like approach to the conduct of policy. There has been a great deal of progress made in identifying simple rules that appear to perform well in a variety of models and environments. Such robust rules can form a basis for developing more systematic, rule-like policymaking.

One important and desirable characteristic of a systematic and rule-like approach to policy relates to communication. In particular, it is an approach that is easily communicated to the public and thus greatly improves the transparency and predictability of monetary policy, which reduces surprises. The public and markets are more informed about the course of monetary policy because they understand how policymakers are likely to react to changing economic circumstances. Equally important in my view is that greater clarity about the policymakers' reaction function strengthens accountability and thus can serve to preserve the central bank's independence.

When I began my term I expected to build on the monetary policy framework I had inherited from Paul Volcker and Alan Greenspan I believed that a still more transparent approach would make monetary policy even more effective and further strengthen the Fed's institutional credibility. In particular, as an academic I had written favorably about the flexible inflation-targeting approach used by the Bank of England and a number of other central banks. [T]hese central banks provided a clear framework to help the public and market participants understand and anticipate policy actions I was confident that we could adapt this type of framework to the Federal Reserve's dual mandate to promote both maximum employment and price stability. Indeed, central banks using this framework were already, in practice, often pursuing economic objectives in addition to low and stable inflation--hence the term, "flexible" inflation targeting. Because the financial crisis and its aftermath naturally occupied so much of policymakers' attention, progress toward a more explicit policy framework at the Federal Reserve was slower than I had hoped. Nevertheless, progress was made. In the minutes of its October 2007 meeting, the FOMC introduced its quarterly Summary of Economic Projections (SEP), which included FOMC participants' projections of key macroeconomic variables such as inflation, gross domestic product (GDP) growth, and the unemployment rate. Over time, we added long-run projections of inflation, growth, and unemployment, as well as projections of the path of the target federal funds rate consistent with each individual's views of appropriate monetary policy We took another important step in January 2012, when the FOMC issued a statement laying out its longer-run goals and policy strategy.2 The statement established, for the first time, an explicit longer-run goal for inflation of 2 percent, and it pointed to the SEP to provide information about Committee participants' assessments of the longer-run normal unemployment rate, currently between 5.2 and 6 percent.

Although my FOMC colleagues are not ready to choose a particular policy rule or reaction function to govern policy, we continue to explore the efficacy of monetary policy rules as guides to policy, as indicated in the minutes of the July 31-August 1, 2012 FOMC meeting. I believe we should continue to identify simple rules that work across a variety of economic models and try to communicate more information about the Fed’s policy reaction function. We could improve policy transparency and communications by identifying the key economic variables on which we base our policy decisions and then frame the rationale for any change in policy around changes in these key variables. If the Fed is systematic about how it sets policy in normal times, the public will form more accurate judgments about the likely course of policy. This will not only improve the efficacy of monetary policy in normal times by reducing uncertainty and promoting stability, it will also increase the efficacy of forward guidance in extraordinary times, like the ones we find ourselves in today.

The Feds failure to communicate internally owes to an irony of increased openness. In 1994, under considerable Congressional pressure, the Fed became more transparent. One initiative was for historians. The FOMC decided to release lightly edited, but otherwise complete, transcripts of every meeting, five years after the fact.

What followed was a predictable social dynamic that is never factored in by economists in their theoretical reasoning that more transparency is better. Starting that year, speakers at an FOMC meeting were given a rough draft of their remarks a few weeks after each meeting. Most learned, to their surprise, that they were a lot less lucid speakers than they had imagined. Off-the-cuff responses to prior speakers looked unthoughtful in black and white. Almost immediately, some began bringing prepared remarks. This set off a readiness race that ended with virtually everyone reading from prepared texts.

Meetings got longer and less spontaneous. More problematic still, meetings became a less useful way of exchanging information and changing minds. This led to a new dynamic: When policy views are scripted, the window to influence views opens before the meeting, when scripts are being written, not during the meeting, when scripts are being read. Thus, Fed officials give more speeches and interviews before meetings to signal each other what they will read at the meeting. If a policy issue is contentious -- if it is a close call -- then the volume cranks up. It just so happens that the free investing world is listening to that conversation.

“Greater transparency should be achievable for us,” Lacker said in response to a question about the Fed’s internal deliberations on communication policy. “For a long time I have advocated an explicit numerical inflation objective.”

Under a framework established by the [Dodd-Frank] act, the Federal Reserve will, by December 1, provide detailed information regarding individual transactions conducted across a range of credit and liquidity programs over the period from December 1, 2007, to July 20, 2010. This information will include the names of counterparties, the date and dollar value of individual transactions, the terms of repayment, and other relevant information. On an ongoing basis, subject to lags specified by the Congress to protect the efficacy of the programs, the Federal Reserve also will routinely provide information regarding the identities of counterparties, amounts financed or purchased and collateral pledged for transactions under the discount window, open market operations, and emergency lending facilities. 

[F]acts, not force, should be the predominant policy response. Prevailing wisdom has it that policymakers must overreact when markets do. In my view, this is an uncertain proposition. If a problem were unique or isolated, game theory suggests that overwhelming force might serve policymakers' interests. But, these problems are not isolated. And it is no game. Markets will continue to clamor for more explicit government commitments. Better to feed the proverbial beast with more facts than force. The Federal Reserve-led stress tests are but one example where the balance was reasonably struck.

At the same time, in a democratic society like our own, institutional independence brings with it fundamental obligations of transparency, responsiveness, and accountability. The Federal Reserve is already one of the most transparent and accountable central banks in the world, providing voluminous information and explanation concerning all of its activities. However, I believe that we should be prepared to do even more, to become even more transparent. It is essential that the public have the information it needs to understand and be assured of the integrity of all our operations, including all aspects of our balance sheet and our financial controls.

The FOMC has chosen not to announce such a quantitative guideline, although many past and current participants on the Committee have expressed individual preferences or “comfort zones” about ranges of inflation that they personally feel are appropriate objectives for policy. Within the past year, the FOMC has started publishing the ranges and central tendency of the inflation forecasts of the participants on a three-year horizon. These forecasts generally have been consistent with the revealed “comfort zones.” In the media, midpoints of these forecasts are often associated with an implicit FOMC objective for trend inflation. This represents important progress concerning the transparency of the FOMC inflation objective. Still, there is some risk that if the evolving inflation situation appears inconsistent with the inflation objective that is inferred from the revealed preferences of the individual FOMC participants, the anchor for inflation expectations may start to drag or come completely loose.

 think that, to too great an extent, we’ve been throwing information out there without being clear in our minds what the message is. … And the way I’ve made this point in several speeches is that the issue is not transparency, but communication. Transparency implies that you throw back a curtain and let everybody look in. We too often dump the data without explaining what to make of it and why we’re doing it. What we need to do is not increase the material that we put out there, but we need to increase the interpretation and explanation, and we need to clarify the message. I don’t think there is enough of that happening.

Among the most important criteria for judging the effectiveness of communications and transparency, then, is whether or not they impede making the best possible policy decisions.  Transparency should not be allowed to inhibit the free give and take and the testing of ideas at meetings that are so important to reaching good decisions.  And communication must deal with the diversity of views on the policy committee; that diversity is a strength of policy committees, but it can make it challenging to arrive at a clear, consistent public explanation of a policy decision, because policymakers can arrive at the same policy position based on different rationales.  Good communication must also take into account uncertainty.  Understandably, market participants want to know what is going to happen next--to the economy and to policy.  But we cannot say more than we know, and we should strive to avoid giving people the impression that we know more than we do. 

Greater clarity about the Fed's goals and strategies actually helps in achieving them.