CENTRAL BANK SECRECY, INTEREST RATES,

AND MONETARY CONTROL

THOMAS F. COSIMANO and JOHN 6. VAN HUYCK*

W e construct a dynamic rational expectations model of thefederalfinds and deposit

market that provides a rationale for central bank secrecy about current moneta y
aggregate objectives. In this analysis, the Trading Desk values secrecy because it reduces
the influence of monetary control policy on interest rates. W e then examine actual
U.S. experience with monetary control and determine that the reserve bias predicted
by the model is present in the datafrom 2978 to 1985. Finally, w e demonstrate that
central bank secrecy may not lower the value of commercial banks.

I. INTRODUCTION gues that disclosure of the current policy

Central banks are notoriously secretive
not only about the policy making process
but also about the actual policy adopted.
For example, the Federal Open Market
Committee of the Federal Reserve System
(hereafter denoted FOMC) does not keep
minutes of its policy meetings and does
not disclose the Domestic Policy Direc-
tive-the adopted policy-until the direc-
tive is no longer current. While it is easy
to rationalize secrecy about the policy
making process, intuitively, secrecy about
the adopted policy is puzzling since the
uncertainty created might be expected to
inhibit a central bank's ability to achieve
the adopted policy.
The FOMC provided several arguments
for its policy of non-disclosure in Merrill
v. FOMC, one of which was the "inappro-
priate market reaction" defense. The "in-
appropriate market reaction" defense ar-
Department of Finance at the University of Notre
Dame and Department of Economics at Texas ALM
University. Ron Balvers, Michael Dotsey, Burkhard
Drees, Marvin Goodfriend, Raymond Lombra,
Thomas Mayer, Carlos Pinerua, Richard Sheehan, and
Carl Walsh made helpful comments on earlier versions
of this paper. Lisa Narbut provided research assis-
tance.
would cause markets to move interest
rates in a manner contrary to the central
bank's objectives.' This paper uses a
choice-theoretic framework to formally
examine the "inappropriate market reac-
tion" defense of central bank secrecy.
Specifically, this paper provides a ratio-
nale for secrecy about a central bank's
current monetary aggregate objectives in
a dynamic rational expectations model of
the federal funds and deposit market. In
the model, secrecy forces commercial
banks to solve a bivariate signal extraction
problem in which they use the current
federal funds rate and the current deposit
rate to estimate both the current reserve
target and future reserve targets. The sig-
nal extraction problem results in the fed-
eral funds rate being less sensitive to the
current level of reserves.
Central bank concern for the level of
interest rates can induce it to consistently
set total reserves above its current reserve
target. Secrecy, by reducing the sensitivity
of the interest rate to the current level of
reserves, lowers the marginal interest rate
cost of moving towards the central bank's
1. See Goodfriend [1986]and Mayer [1987l.

370
Economic Inquiry
VO~.XXM,July 1993,370-382 @WesternEconomic Association International
 COSIMANO I% VAN HUYCK: CENTRAL B A N K SECRECY
reserve target and, hence, lowers the up-
ward bias in total reserves. Consequently,
the central bank prefers secrecy to disclo-
sure. In this analysis, the Trading Desk
values secrecy because it reduces the in-
fluence of its monetary control policy on
interest rates.
Under both secrecy and disclosure, our
analysis predicts that the Trading Desk
will exhibit an upward bias in its choice
of total reserves and, hence, in its choice
of monetary aggregates such as M1 and
M2. In section IV, we attempt to determine
if M1 was above target on average from
1978 to 1985. The mean percentage differ-
ence between M1 and the mid-point of the
ranges for M1 contained in the Domestic
Policy Directive over the period 1978 to
1985 was 1.6 percent per year, which is
greater than zero at the 5 percent level of
statistical significance.
Conventional wisdom holds that the
welfare of commercial banks is lowered by
central bank secrecy. The influence of cen-
tral bank secrecy on the variability and
predictability of interest rates is a common
object of analysis. A standard result is that
secrecy reduces the predictability of inter-
est rates.2 However, a second more subtle
effect of secrecy is that the information
regime changes the covariance structure of
the economy.
Given the choice-theoretic framework
of this paper, it is possible to examine the
conjecture that central bank secrecy low-
ers the value of commercial banks. In
general, it is not possible to order the
relative value of commercial banks under
the alternative information regimes. The
2. See Dotsey (1987, Tabellini [1987, and Rudin
[1988] on the relationshipbetween secrecy and interest
rate variability and predictability. See Lombra and
Struble [1979] on the relationshipbetween interest rate
predictability and the welfare of financial institutions.
Our manuscript, Cosimano and Van Huyck [1991],
demonstrates that there is no necessary relationship
between interest rate predictability and commercial
bank value. See Hakansson et al. [1982] for an abstract
discussion of necessary and sufficient conditions for
information to have social value in pure exchange.
371
information regime influences the value of
commercial banks through two channels.
Secrecy motivates the trading desk to sup-
ply less reserves on average, which re-
duces commercial bank profits; but se-
crecy increases the covariance of deposits
with the spread between the loan rate and
the deposit rate, which increases commer-
cial bank profits. The analysis reveals that
for reasonable parameter values central
bank secrecy can increase the value of
commercial banks. Consequently, it is pos-
sible that both the central bank and com-
mercial banks prefer secrecy to disclosure
of the current monetary aggregate objec-
tive.
II. THE TRADING DESKS MONETARY
CONTROL PROBLEM
The monetary policy process in the
United States can be characterized as fol-
lows. The FOMC solves a decision prob-
lem involving objectives such as high em-
ployment, economic growth, price stabil-
ity, and exchange rate stability. The
FOMC's decision problem results in a di-
rective to the Trading Desk at the Federal
Reserve Bank of New York, involving
growth rate targets for monetary aggre-
gates and a tolerance range for the federal
funds rate.3
In this section we formalize a Trading
Desk's monetary control problem. Sup-
pose the Trading Desk engages in open
market operations in an attempt to
achieve the intermediate targets contained
in the policy directive from the Central
Bank. The Trading Desk knows the current
reserve target, which is contained in the
Policy Directive to the Trading Desk, but
future reserve targets are uncertain. As-
sume that the Trading Desk treats interme-
diate targets as exogenously given and
that the reserve targets, Rf, evolve accord-
ing to the following stochastic process:
3. See Cosimano and Van Huyck [1989].
372 ECONOMIC INQUIRY
where wt is normally distributed with
mean zero and variance u$ and a, is pos-
itive and less than the reciprocal of the
Trading Desk’s discount rate. The stochas-
tic nature of the reserve targets reflects the
Central Bank’s response to changing mac-
roeconomic conditions. In this paper, se-
crecy refers to an information regime in
which the Central Bank does not disclose
the current reserve target, RT, to the public
until it is no longer current.
The Trading Desk chooses total re-
serves, R , to minimize the following loss
function:
m constructs an explicit dynamic rational
(2)S1= C 6’-’ET “(1- hXR, - RT)*]/2 + hf,),
t-T
where fi denotes the federal funds rate in
period t, 6 denotes the Trading Desk’s time
discount rate, and El denotes the expecta-
tion operator conditional on the Trading
Desk’s information set at time T, which
contains realizations of variables dated T
or earlier. The parameter h formalizes the
trade off between the reserve target and
federal funds rate objective.
A concern for low interest rates, h > 0,
weakens the Trading Desk’s incentive to
achieve the reserve targets exactly.
Lombra and Moran [1980] a n d
Karamouzis and Lombra [1989] document
the FOMC‘s practice of choosing inconsis-
tent targets for monetary aggregates and
interest rates from the menu of policy
options compiled by the staff. Karamouzis
and Lombra [1989, 61 conclude that ”this
tendency to select seemingly inconsistent
short-run alternatives calling for ‘low’
money growth and ‘low’ interest rates in
order to secure a unanimous or near unan-
imous vote on the Directive seems to be
an e n d u r i n g characteristic of Fed
p~licymaking.”~ For whatever reason, it
appears that the Trading Desk is con-
cerned with both reserve and interest rate
objectives and, hence, for descriptive pur-
poses we treat h as greater than 0 but less
than 1.
In order to formalize the constraints on
the Trading Desk’s decision problem, we
need to specify how the federal funds rate
is influenced by the Trading Desk’s open
market operations. It seems reasonable to
believe that the monetary control problem
is a dynamic problem, that is, the expected
supply of reserves in the future will influ-
ence the current federal funds rate. Con-
sideration of portfolio adjustment costs
(see McCallum [1985,584]) or loan adjust-
ment costs (see Cosimano [1988, 1201)
would produce such dynamics. Section VI
expectations model of the commercial
banking industry in which the dynamics
arise because of deposit adjustment costs.
We delay our discussion of the commercial
banking industry in order to focus on the
Trading Desk’s monetary control problem.
Assume that the federal funds rate is de-
creasing in current reserves, but increasing
in lagged and expected future reserves.
Specifically, assume that the federal
funds rate is related to reserves by the
following equation:
The parameters pOI pl, p2 are positive
constants, which are functions of the
parameters of the supply and demand for
deposits. As shown in section VI, the
contemporaneous effect of reserves on the
funds rate is greater than the lagged or
4. See Kane [1980]and Woolley [1984]for a dis-
cussion of political pressure on the Federal Reserve
System for low interest rates.
 COSIMANO & VAN HUYCK CENTRAL BANK SECRECY
expected future effect, that is, p1 > p2. The
parameter p is the representative
commercial bank’s discount rate. The
random variable ut denotes an industry-
wide cost shock and the random variable
e, denotes a deposit supply shock. Let ui
denote the variance of ut and 0: denote
the variance of e,. The industry-wide cost
shocks and the deposit supply shocks are
assumed to be uncorrelated. The term Ei
is the expectation operator conditional on
the representative commercial bank’s
information set at time t .
Secrecy denotes the information regime
in which commercial banks do not observe
the current innovation to the reserve tar-
get, yt. Disclosure denotes the information
regime in which commercial banks do ob-
serve the current innovation, y.~r. Let fi de-
note the representative commercial bank’s
information under secrecy, and let If de-
note the information set under disclosure.
Equation (3) reflects the commercial
banking industry’s response to Trading
Desk behavior and is a constraint on the
Trading Desk’s decision problem. An im-
portant characteristic of equation (3)is the
dependence of the federal funds rate on
expected future total reserves, which the
Trading Desk can and does influence. This
influence will depend on the information
regime.
Substituting the federal funds rate
equation, (3), into equation (2) gives the
Trading Desk‘s constrained loss function:
m
(4)S, = C t-1
6’-’El ([(l - h)(R, - Ry)2]/2
where R1-,is an initial condition. The final
component needed to complete the ana-
lytical framework is the determination of
the commercial banks‘ expectation of fu-
.*
ture reserves,. [E!R,X. ,..I.
373
The analysis derives a discretionary
equilibrium under both a regime of disclo-
sure and a regime of secrecy. A discretion-
ary equilibrium consists of the following
features: an expectations function, which
determines the commercial banks’ expec-
tation of future reserves, (E!R,+l}r, as a
function of the commercial banks’ current
information, either I; or If; a sequence of
decision rules for the Trading Desk, which
determines the Trading Desk’s choice of
total reserves as a function of the Trading
Desk’s current information. In a discre-
tionary equilibrium the sequence of deci-
sion rules minimizes the Trading Desk’s
constrained loss function, given the com-
mercial banks’ expectation function, and
the commercial banks’ expectations are
the best linear unbiased forecast of total
reserves, given the Trading Desk’s deci-
sion rules.5 The alternative discretionary
equilibria discussed in the following sec-
tions result from alternative assumptions
about the information available to the
commercial banks.
111. DISCLOSURE
To focus the analysis and provide a
useful benchmark case, suppose that, con-
trary to actual practice, the Central Bank
disclosed the current reserve target, R:. In
a linear-quadratic-gaussian framework, a
reasonable conjecture for the functional
form of the Trading Desk’s decision rule,
which turns out to be correct, is
(5) R, = uo + n,RT,
where uo and al are parameters to be de-
termined. If the conjectured decision rule
5. See Cosimano and Van Huyck [1989]for an anal-
ysis of dynamic monetary control when the Trading
Desk can make commitments. Secrecy undermines the
ability of the Trading Desk to make commitments. An
interesting result is that the value of the Trading Desk’s
loss function can be smaller under a regime of discre-
tion and secrecy than under a regime of commitment
and disclosure.
374 ECONOMIC INQUIRY
satisfies the conditions of a discretionary
equilibrium, then the commercial banks
would use equations (5) and (1)to forecast
total reserves.
Substituting (1)into (5) and taking ex-
pectations conditioned on If, which in-
cludes RT, gives the following expecta-
tions equation for the commercial banks:
f o r t = T, ~ + 1 ,... . Under disclosure the
Trading Desk's current choice of total re-
serves, R,, does not influence the commer-
cial banks' expectations of R,+,, because
the commercial banks know the current
total reserve target, RT.
The final step in deriving a discretion-
ary equilibrium under disclosure is to ver-
ify that the conjectured decision rule, (5),
minimizes the Trading Desks constrained
loss function, (4), subject to the conjec-
tured expectations equation, (6). Substitut-
ing (6) into (4) and taking the derivative
with respect to R, gives the Euler condi-
tions for this problem, which can be re-
written as follows:
f o r t = T, T+ 1, ... . Equation (7) has the
conjectured functional form of equation
(5) where uo equals h(p, - 6p2)/(l - h) and
u, equals 1.Since the contemporaneous ef-
fect of reserves on the funds rate is greater
than the lagged effect, that is, p1 > p2 and
since 6 is less than 1 by assumption, uo is
a positive constant.
The Trading Desk's decision rule, (7),
prescribes setting total reserves above the
current reserve target by some constant
amount. The analysis predicts that the
Trading Desk will exhibit an upward bias
in its choice of total reserves and, hence,
in its choice of monetary aggregates such
as M1 and M2. The size of the bias de-
pends on how much weight the Trading
Desk puts on keeping the federal funds
rate low, that is, parameter h. If h equals
0, then the Trading Desk achieves the
reserve target in every period and there is
no bias. The greater the concern for low
interest rates the larger the bias.6
IV. SECRECY
In reality, central banks almost never
disclose their current policy objectives and
often go to great lengths to conceal them.
Consequently, although providing a use-
ful benchmark case, the analysis of dy-
namic monetary control under disclosure
fails to explain observed central bank se-
crecy. Suppose that the Central Bank does
not disclose the current reserve target con-
tained in the policy directive and that this
target is not inferable from known Central
Bank objectives and perceivable macro-
economic conditions.
Under secrecy commercial banks fore-
cast R,,, using their knowledge of current
observable variables and of the Trading
Desk's decision problem. Again, a reason-
able conjecture for the functional form of
the Trading Desk's decision rule, which
turns out to be correct, is R, = bo + b,RT,
where bo and b, are parameters to be
determined. Given the conjectured deci-
sion rule and equation (l), the expecta-
tions function for commercial banks under
secrecy is
6. A referee has pointed out that there is a parallel
between the reserve bias demonstrated in our discre-
tionary analysis of the dynamic monetary control
problem and the inflation bias demonstrated in Barro
and Gordon's (19831 discretionary analysis of the re-
peated inflation surprise game.
 COSIMANO & VAN HUYCK CENTRAL BANK SECRECY
for t = T, ~ + 1 ...
, . Unlike disclosure, under
secrecy the banks can only estimate RT
based on knowledge of the model and on
contemporaneous observation of the fed-
eral funds rate and the deposit rate, that
is, the commercial banks confront a bivar-
iate signal extraction problem.
The bivariate signal extraction problem
is solved in the appendix using the com-
mercial banking model developed in sec-
tion VI. Observing the federal funds rate
and the deposit rate when combined with
the model and the history of all stochastic
forcing processes allows commercial
banks to infer two signals
and
where tf denotes the deposit rate and
Qi-l denotes all variables dated t-1 or ear-
lier. The linear least squares projection of
4
wt on and s; is
(It will be useful to know that 0 < dp, < 1
in what follows.) Under secrecy, commer-
cial banks’ perception of the current inno-
vation to the reserve target E[y,lZ;] is a
function of current reserves, R,. The Trad-
ing Desk’s current choice of total reserves
influences the federal funds rate, which in-
fluences the commercial banks’ perception
of the innovation to the reserve target,
and, hence, influences the commercial
banks’ forecast of total reserves in period
t+l, that is,
37s
The final step in deriving a discretion-
ary equilibrium under secrecy is to verify
that the conjectured decision rule mini-
mizes the trading desk’s loss function sub-
ject to the conjectured expectations equa-
tion. Substituting (9) and (10) into (4) and
taking the derivative with respect to R,
gives the Euler conditions for this prob-
lem, which can be rewritten as follows:
for t = T, ~ + 1 ...
, . Equation (11)is the best
response to the commercial banks’ expec-
tation equations and it has the conjectured
functional form of the decision rule used
to derive the expectations equation: b,
equals h[p1 (1-alPp2d) -bpd/(l-h) and bl
equals 1. Since it can be shown that b, is
positive, the analysis predicts a positive
reserve bias under secrecy. Comparing the
Trading Desk‘s decision rule under disclo-
sure, (7), with its decision rule under se-
crecy, (ll),reveals that b, = al and b, = uo
- a1P P Z P l d h / ( W . The term %P P2Pldh
/(l-/z) is positive and reflects the influence
of current reserves on expected future re-
serves under secrecy. Since alpp2pldh
/(l-h) is positive, the analysis predicts that
secrecy reduces the upward bias in the
Trading Desk’s choice of total reserves.
A reasonable conjecture, given the
smaller bias under secrecy, is that the
Trading Desk would prefer to keep the
reserve target secret. To confirm this con-
jecture, calculate the value of the Trading
Desk’s loss function under secrecy. Substi-
tuting the stochastic process for the re-
serve target, (l),the forecasting equations
(9) and (lo), and the Trading Desk’s deci-
sion rule, (ll),into the constrained loss
function, equation (4)-and after some al-
gebra-gives
376 ECONOMIC INQUIRY
where S; is the value of the Trading Desk's
loss function under disclosure. Inspection
of equation (12) reveals that S: < S:, be-
cause b < l and alp,pf/2<1. Conse-
quently, the value of the Trading Desk's
loss function is smaller under secrecy.
A concern for the level of interest rates
results in the Trading Desk choosing ac-
tual reserves greater than target reserves.
The size of this reserve bias depends on
the sensitivity of the federal funds rate to
the current level of reserves. Because com-
mercial banks cannot perfectly distinguish
between changes in reserves and random
shocks to the federal funds market, se-
crecy reduces the sensitivity of the federal
funds rate to the current level of reserves.
Hence, secrecy lowers the marginal inter-
est rate cost of moving towards the Trad-
ing Desk's reserve target and, thus, lowers
the upward bias in actual reserves. The
Trading Desk values secrecy because it
reduces the influence of its monetary con-
trol policy on interest rates.
Specifically, the Trading Desk does bet-
ter under a regime of secrecy because the
resulting bivariate signal extraction prob-
lem reduces the elasticity of the federal
funds rate with respect to current total
reserves, R,. Substituting the relevant ex-
pectations function and decision rule into
the federal funds rate equation, (3), gives
the reduced-form expression for the funds
rate under disclosure and secrecy. The
sensitivity of the funds rate to current total
reserves under disclosure and secrecy is
The funds rate is less sensitive to total re-
serves under secrecy. This result depends
on three features of the analysis. First, the
reserve targets must be positively au-
tocorrelated, that is, a, > 0. Second, the
commercial banks must solve a dynamic
decision problem, that is, p2 > 0. Third, the
current reserve target must be secret, that
is, (6>0.
Since the funds rate is less sensitive to
total reserves under secrecy, a given bias
in the supply of total reserves is associated
with a lower interest rate. When the objec-
tives of the Trading Desk include a con-
cern for the level of interest rates, h > 0,
secrecy lowers the value of its loss func-
tion. In this analysis, the Trading Desk
values secrecy because it reduces the in-
fluence of its monetary control policy on
interest rates.
V. WAS M1 ABOVE TARGET ON AVERAGE
FROM 1978 TO 19857
The previous sections provide a simple
analysis of the Trading Desk's Monetary
Control problem. The analysis has ab-
stracted from many considerations some
of which may be important. This section
examines actual U.S. experience with
monetary control to determine if the pre-
dicted bias is observed.
The M1 targets are constructed from the
M1 target ranges contained in the Domes-
tic Policy Directive reported in the Federal
Reserve Bulletin as follows. First, calculate
the mid-point of the M1 target ranges to
obtain an annual growth rate target. Sec-
ond, convert the annual growth rate target
to growth rate target for the intermeeting
period. Third, obtain the money supply
figures available to the FOMC at the time
of their meeting7 Fourth, calculate-using
continuous compounding- the M1 target
7. The authors thank Richard Sheehan for provid-
ing this data.
 COSIMANO & VAN HUYCK: CENTRAL BANK SECRECY
consistent with the best available figure
for M1 and the intermeeting growth rate
target. Table I reports the constructed time
series for the M1 target, the actual value
of M1, the difference between the actual
and target value of M1,and the percentage
difference.
While M1 is not uniformly above target,
the mean percentage difference is 0.2 per-
cent over an intermeeting period. The null
hypothesis that the mean percentage dif-
ference is not positive generates a t-statis-
tic of 1.71, which exceeds the critical value
of 1.658 at the 5 percent level of statistical
significance. Given an average of eight
meetings a year, the mean percentage dif-
ference between M1 and the mid-point of
the ranges for M1 contained in the Domes-
tic Policy Directive over the period 1978 to
1985 was 1.6 percent per year. Hence, the
data does not contradict the model’s pre-
diction that a concern for the level of
interest rates, which is also expressed in
the Domestic Policy Directive over this
period, biases monetary aggregates above
the relevant monetary targets.
VI. CENTRAL BANK SECRECY AND THE
CDMMERCIAL BANKING INDUSTRY
While something like the federal funds
rate equation used in our analysis could
be consistent with a number of commer-
cial banking models, this section derives
it from an explicit model. This will not
only allow us to derive the federal funds
rate equation and formalize the signal
extraction problem, but also allow us to
formalize secrecy’s influence on the value
of the commercial banks.
The banking industry is composed of
n competitive commercial banks. The ith
commercial bank chooses deposits, Di,
loans, Li, and federal funds, 4, to maxi-
mize the present value of expected profits,
Vi:
377
where p is one over one plus the bank’s
6
return on equity, is the loan rate, $ is
the deposit rate, pi is the random compo-
nent of the marginal cost of deposits, and
all C ~ are
S positive parameters.
Banks hire labor and capital to provide
liquidity services to their depositors.s
Hence, the marginal cost of deposits de-
pends on the cost of these resources. The
quadratic term in the level of deposits
represents the increasing cost of providing
liquidity with fixed banking locations and
check clearing facilities. The marginal cost
of deposits also contains a random com-
ponent, pf, which represents both bank
specific and industry wide shocks. (Notice
that without these cost shocks the com-
mercial banks could infer the current in-
novation in the reserve target from the
funds rate and deposit rate signals and,
hence, we would not have a meaningful
distinction between disclosure and se-
crecy.) The value function is linear in rev-
enue from loans and federal funds.
The model’s dynamics arise from the
quadratic cost of adjustment term in equa-
tion (14).The adjustment term could rep-
resent the cost of adjusting labor and cap-
ital to provide changing levels of liquidity
(see Sargent [1987] on labor and capital
adjustment costs) or the adjustment term
could represent transaction specific in-
vestment in customer relationships. If a
bank wants to attract a customer from a
competitor, it must pay a portion of the
cost of setting up a customer relationship.
This cost includes the loss of interest in-
come on float during the change, evaluat-
8. See Saving [19n], Cosimano [1987], or Sweeney
[1988].
378 ECONOMIC INQUIRY

TABLE I
M1 Target Derived from Domestic Policy Directive
and Actual M1: 1978-1985
Date of Percent
Meeting M1 Target Actual M1 Actual-Target Difference

Jan. 17,1978 341.53 336.10 -5.43 -1.6%

Feb. 28,1978 336.78 335.90 -0.88 -0.3
Mar. 21, 1978 337.45 341.70 4.25 1.3
Apr. 18,1978 343.34 350.50 7.16 2.1
May 16,1978 352.35 349.70 -2.65 -0.7
June 20,1978 351.79 354.10 2.31 0.7
July 18, 1978 355.68 353.10 -2.58 -0.7
Aug. 15,1978 355.14 357.30 2.16 0.6
Sep. 19, 1978 359.22 359.90 0.68 0.2
Oct. 17, 1978 362.15 362.10 -0.05 -0.0
Nov. 21, 1978 363.49 360.70 -2.79 -0.8
Dec. 19, 1978 362.64 357.60 -5.04 -1.4
Feb. 06,1979 359.66 360.10 0.44 0.1
Mar. 20, 1979 361.76 359.40 -2.36 -0.6
Apr. 17,1979 361.47 364.90 3.43 0.9
May 22,1979 366.13 368.60 2.47 0.7
July 11,1979 370.19 372.30 2.11 0.6
Aug. 14, 1979 374.45 376.90 2.45 0.7
Sep. 18,1979 378.09 377.80 -0.29 -0.1
Oct. 06, 1979 379.76 379.20 -0.56 -0.1
Nov. 20, 1979* 382.07 381.70 -0.37 -0.1
Jan. 09, 1980 383.35 389.30 5.95 1.6
Feb. 05,1980 391.17 391.30 0.13 0.0
Mar. 18, 1980 393.18 390.40 -2.78 -0.7
Apr. 22,1980 391.90 388.60 -3.30 -0.8
May 20,1980 392.90 391.60 -1.30 -0.3
July 09,1980 394.35 394.30 -0.05 -0.0
Aug. 12,1980 397.71 403.00 5.29 1.3
Sep. 16,1980 405.51 409.70 4.19 1.o
Oct. 21, 1980 411.49 411.90 0.41 0.1
Nov. 18, 1980 413.65 412.40 -1.25 -0.3
Dec. 19, 1980 414.87 416.40 1.53 0.4
Feb. 03,1981 419.97 420.60 0.63 0.2
Mar. 31, 1981 423.72 430.90 7.18 1.7
May 18, 1981 432.75 429.00 -3.75 -0.9
July 07, 1981 432.22 433.70 1.48 0.3
Aug. 18, 1981 437.79 431.70 -6.09 -1.4
Oct. 06, 1981 435.19 433.20 -1.99 -0.5
Nov. 18, 1981 436.12 440.60 4.48 1.0
Dec. 22, 1981 442.89 450.50 7.61 1.7
Feb. 01,1982 450.50 449.00 -1.50 -0.3
 COSIMANO & VAN HUYCK: CENTRAL BANK SECRECY 379

TABLE I continued
M1 Target Derived from Domestic Policy Directive
and Actual M1: 1978-1985
Date of Percent
Meeting M1 Target Actual M1 Actual-Target Difference
Mar. 28,1982 450.81 449.90 -0.91 -0.2
May 18,1982 451.46 452.50 1.04 0.2
June 30,1982 455.98 453.40 -2.58 -0.6
Aug. 24,1982 456.02 461.00 4.98 1.1
Nov. 15,1982‘ - - - -
Dec. 21, 1982 - - - -
Feb. 09,1983 - - - -
Mar. 28, 1983 499.39 506.90 7.51 1.5
May 24,1983 511.34 508.30 -3.04 -0.6
July 12, 1983 512.41 516.90 4.49 0.9
Aug. 23,1983 521.08 517.80 -3.28 -0.6
Oct. 04, 1983 522.29 515.70 -6.59 -1.3
Nov. 15,1983 518.19 522.70 4.51 0.9
Dec. 20,1983 526.32 523.60 -2.72 -0.5
Jan. 31, 1984 529.14 536.10 6.96 1.3
Mar. 26, 1984 541.46 539.40 -2.06 -0.4
May 22, 1984 544.79 544.60 -0.19 -0.0
July 16, 1984 547.47 547.30 -0.17 -0.0
Aug. 21,1984 550.45 549.60 -0.85 -0.1
Oct. 02, 1984 552.76 544.70 -8.06 -1.5
Nov. 07,1984 546.58 547.10 0.52 0.1
Dec. 17, 1984 552.99 559.60 6.61 1.2
Feb. 12,1985 564.78 570.60 5.82 1.0
Mar. 26, 1985 575.88 577.60 1.72 0.3
May 21,1985 582.94 596.00 13.06 2.2
July 10, 1985 599.15 601.90 2.75 0.5
Aug. 20,1985 607.82 610.40 2.58 0.4
Oct. 01, 1985 614.22 613.60 -0.62 -0.1
Nov. 04, 1985* 617.85 626.10 8.25 1.3
*The definition of M1 changes between the Nov. 20,1979 and Jan.9,1980 meetings. The directive
does not contain M1 target ranges for the following meetings: Nov. 15, 1982; Dec. 21, 1982;
Feb. 9,1983. The FOMC ceased including M1 targets after the May 20, 1986 meeting.
Source: Federal Reseive Bulletin, various issues.

ing the cost and benefits of doing business
with a new bank, and learning the loca-
tions, hours, and procedures of the new
bank. Additionally, it is costly to establish
the new customer’s account. Flannery
[1982]presents evidence that deposit ad-
justment costs are an important source of
dynamics.
The loan market will only be used to
close the model in order to calculate the
value of commercial banks under disclo-
sure and secrecy. The cost of loans in-
380 ECONOMIC INQUIRY
creases at an increasing rate, which repre-
sents the resource cost of evaluating and
monitoring loans. For simplicity, the anal-
ysis assumes that loan demand is inelas-
tic.9
Assume that a bank holds neither ex-
cess nor borrowed reserves. Relaxing this
assumption merely obscures the analysis
of secrecy in this paper without contribut-
ing insight. Consequently, the balance
sheet constraint of a bank reduces to
Fi = (1-O)Di - Li, where 8 is the required
reserve ratio.
The Euler equation for a bank's deposit
demand is found by substituting the bal-
ance sheet constraint into equation (14)
and taking the derivative with respect to
D:. Let D, denote the sum of the deposits
supplied by the n banks. Summing across
the n Euler equations gives the aggregate
deposit demand:
(15) D, = (n(l-O)f, - nt + c2D,-,
where u , is the sum of the pi and is serially
uncorrelated with mean zero and finite
variance.10
To complete the market for deposits,
assume that the aggregate supply of de-
posits depends linearly on the spread be-
tween the federal funds rate and the de-
9. See Cosimano [1988] for a more developed
model of the loan market.
10. The signal extraction problem arises because
commercial banks do not observe P I . If was observ-
able, then commercial banks could infer the current
innovation to the reserve target from the deposit rate
and the federal funds rate. In their analysis of the
FOMC's decision problem, Cukierman and Meltzer
[1986] and Lewis [1991] argue that imperfect monetary
control causes private agents to solve a signal extrac-
tion problem. Interestingly, the Trading Desk has no
incentive to create ambiguity through imperfect mon-
etary control in order to hide the current reserve target.
In fact, it is possible to show that the Trading Desk
prefers perfect monetary control in the framework of
this paper.
posit rate and on a random shock to de-
posits:
where mo and ml are positive parameters,
and E, is a serially uncorrelated random
variable with mean zero and finite vari-
ance.,' The deposit rate can be found by
using the deposit demand equation (15)
and the deposit supply equation (16) to
solve out for current deposits, which gives
(17) = (1-ndO)f, + dc2D,-l + dc2PE;Dt+,
where d = 1/ [ n + [cl + c2(l+p)]ml 1.
The equilibrium condition for the fed-
eral funds market is obtained by adding
together the balance sheet constraints of
the individual banks and by noting that
L , - D, equals the total reserves deter-
mined by the Trading Desk, R,. The federal
funds market clears when OD,= R,.
Together, the equilibrium conditions for
the deposit market and the federal funds
market yield the federal funds rate that
simultaneously clears the federal funds
and deposit market, which was denoted
equation (3) in section 11:
+ p2R,-, - u , + e ,
where
11. Our analysis focuses on the Trading Desk's
short term monetary control problem. A more complete
model would include the influence of the price level
on deposit demand and supply. However, we do not
believe that these long term considerations will elim-
inate the effect of secrecy illustrated by the analysis.
 COSIMANO & VAN HUYCK: CENTRAL BANK SECRECY
Deriving equation (3) from a choice-the-
oretic analysis of the commercial banking
industry allows us to determine the rela-
tive magnitudes of the parameters. For ex-
ample, we know that p1 is less than one
and greater than p2 as was claimed.
By substituting the Trading Desk's de-
cision rule, the market clearing conditions,
the balance sheet condition, and the first-
order conditions into the ith bank's value
function, (14), it is possible to calculate the
value of a commercial bank, which under
disclosure is
and under secrecy is
(19) E< = [ ii+ c l [ % / ( l - ~ ) + b,I2/2e2
where SE denotes those terms that do not
change with the information regime.
In general, it is not possible to order the
relative value of the ith bank under disclo-
sure versus secrecy. The information re-
gime influences the value of a commercial
bank for two reasons. First, the Trading
Desk chooses a smaller steady state level
of total reserves under secrecy, b, < u,,
which reduces a bank's value; see the
middle term of the right-hand side of
equations (18) and (19). Second, secrecy
increases the covariance between deposits
and the spread between the loan rate and
the deposit rate.
This second more subtle influence of
secrecy on a bank's value is reflected in
the final term of the right-hand side of
381
equation (18) and (19). Notice that because
p,pf < 1 this second influence increases a
bank's value. Under both regimes the vari-
ance of the reserve target increases the cost
of deposit adjustment and, hence, lowers
the value of a commercial bank: c2 > 0.
However, secrecy increases the covariance
between deposits and the spread between
the loan rate and the deposit rate, which
increases the value of a commercial bank.
When the Trading Desk has little con-
cern for the level of the federal funds
rate--h is small-then the steady state
levels of reserves under disclosure and
secrecy are nearly equal and the covari-
ance influence of secrecy dominates.
Hence, for reasonable parameter values
central bank secrecy can increase the value
of commercial banks. Consequently, it is
possible that both the central bank and
commercial banks prefer secrecy to disclo-
sure.
APPENDIX
This appendix derives equation (lo), which
is the optimal forecast of yt based on the cur-
rent information available to the commercial
banks under secrecy: the deposit rate and the
funds rate. Let = fi,#,Qi-l), where Qf-1 de-
notes all variables dated t-1 or earlier. By equa-
tion (3) the federal funds rate allows commer-
cial banks to infer the following signal:
and by equation (17) the deposit rate allows
commercial banks to infer the following signal:
(A2) s'; = 8- E [ 8 I Qi-11 =ylut + Y2et,
where y1 = nde and y2 = (1-nd)e.
The linear least squares projection of yt on 4
and s; is
('43) E[yt I d ] = d4 - cp'd,
382 ECONOMIC INQUIRY
where
and
See Dotsey and King (1986, 411 on t h e solution
of bivariate signal extraction problems. Equa-
tion (10) i n t h e text follows from substituting
( A l ) and (A2) into (A3).
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