STANFORD GRADUATE SCHOOL OF BUSINESS—Casual observers and even some fairly savvy investors often see the U.S. Federal Reserve as a mysterious organization that wields great power over the economy by setting interest rates while offering only the most cryptic remarks about its plans.

In truth, the Fed is more candid today than at any other time in its history, argues James Van Horne, Giannini Professor of Banking and Finance. Van Horne, addressing an Alumni Weekend audience on October 23, traced the role of the U.S. Central Bank over the past century and pointed out some unintended dangers of this trend toward increased transparency.

"Is transparency as it relates to monetary policy really a good thing? I contend that at times it isn't," he said, introducing a talk that reviewed the role of central bankers in the United States and Europe over past several hundreds of years.

When monetary authorities are led to believe that the Fed will notch interest rates up or down slowly in careful, quarter-point moves, Van Horne said, they become "overly confident in their ability to understand the economy, inflation, financial bubbles, and financial excesses." This results in "speculative excesses" and leaves them highly exposed to sudden, dramatic changes in the economy. Transparency in monetary policy is supposed to reduce volatility, but runs the risk of having exactly the reverse effect.

Since 1999, Federal Reserve Chairman Alan Greenspan has dramatically reduced uncertainty over interest rates by foreshadowing his bias a meeting in advance. During a September meeting, for instance, the Fed raised a key interest rate from 1.5 percent to 1.75 percent, and issued statements strongly suggesting that it would continue along that path of small increases. Although these future plans are often disguised as what Van Horne called "crafty statements," he said they are easy enough for any serious Fed watcher to decipher.

"Uncertainty is supposed to be a defining characteristic of the landscape," Van Horne said. "But while Mr. Greenspan seems to talk the talk, I don't believe the Fed in recent years has walked the walk. There has been a distinct evolution over the last 10 years with respect to the walk." Offering a bit of levity into the technical discussion of monetary policy, Van Horne remarked that the increasing predictability of the Fed has corresponded with a similar shift in its chairman. "He's gone from being outwardly witty to purposely bland," he said of Greenspan.

Historically, the Fed did not have such an active role in monetary policy. Its original purpose, following a series of bank panics in the post-Civil War period, was to respond to interruptions in the money supply and stay out of the way when the economy was healthy. Van Horne said that changed during World War II when the Fed took a more active roll in issuing low-interest government treasury bills to help finance the war effort. Its functions evolved again during the late 1960s when mounting inflation created more concerns about a steady monetary supply. By the 1970s, with sky-high inflation and gasoline supply shocks rocking the economy, the Fed was taking a much more proactive role in stabilizing the money supply.

Today, the Fed is generally seen as an institution that actively controls interest and inflation rates, rather than just responding to market forces.

Fed policy is now so transparent that most businesses feel comfortable issuing large amounts of debt, assuming they will be able to pay it off while rates are still low. "And so far, the rolling of the dice has paid off," said Van Horne.

The danger is that the Fed does not ultimately have the power to control the entire economy and all the outside factors that may cause a sudden shift in the money supply.

"This can cause considerable problems," he warned. He said he would like to see the Fed become "more humble and flexible" and more willing to recognize uncertainty in financial markets.