The Fed Tilts its Hand

Is there a case for increased central bank transparency? Bernanke certainly seems to think so.

In the press release which announced the results of the December 2012 meeting of the Federal Open Market Committee (FOMC), the language regarding the timing of the Fed’s eventual movement away from exceptionally low levels of the federal funds rate changed significantly.

Ever since such “guidance” (in central bankers’ parlance) was introduced in the August 2011 press release, the Fed has offered a relatively vague date for the first hike in the Fed Funds rate (originally “at least … mid-2013 “). That date has subsequently been pushed out, and stood at mid-2015 in the October 2012 press release. The December announcement abandoned this language, and tied the eventual rate hike to a specific level of unemployment, conditional on the inflation outlook:

“the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

Long-Term Trend Towards Increased Transparency

This change marks the latest iteration in what has been a 20-odd year trend towards greater transparency in the Federal Reserve’s communications. Under Paul Volcker (Chairman of the Fed between 1979 and 1987) the Fed’s communications were minimal: market observers typically had to decipher the Fed’s policy stance from observations of concealed open-market behavior by the Fed’s traders. After initially resisting pressure to do so, 5 years into his first Chairmanship, Alan Greenspan (Chairman from 1987 until 2006) began announcing his monetary policy simultaneously with its implementation – in the now-familiar FOMC press release format. During Greenspan’s tenure, the Fed also began publishing the minutes of FOMC meetings, somewhat after the fact (the lag between the meeting and the release of the minutes is currently 3 weeks). This  ‘press-release + minutes’ communications format remains in place to this day.

Under Ben Bernanke (Chairman 2006 – Present), the Fed has boldly expanded its mandate in a number of areas: various, highly controversial lending programs initiated during the depths of the financial panic; the large-scale purchase of various debt securities – collectively known as Quantitative Easing; and finally the Fed’s communications regarding future movements in the Federal Funds target rate. Before Bernanke, Greenspan was famous for his “Fed speak”: thinly-veiled language which revealed his biases regarding the future direction of monetary policy, carefully articulated in order to impact different parts of the yield curve (the most notable such communication was his largely unsuccessful attempts to push up longer-term borrowing rates in 2004, an event he somewhat notoriously known as a “Greenspan’s conundrum”). Within the confines of the familiar ‘press-release + FOMC minutes’ format, Bernanke has continued the trend towards increasingly transparent communications: as previously noted, the August 2011 FOMC press release was unprecedented in that it included a forecast for the date of the next change in the Fed Funds target rate. Bernanke tilted his hand further in December 2012 when he replaced this forecast with an explicit reaction function for the first of the rate hikes.

While a first for the Fed, Bernanke’s guidance is hardly at the forefront of the global push by central banks toward greater transparency: in April 2009, Mark Carney at the Bank of Canada made a ‘conditional commitment’ to keep rates on hold until mid-2010, pre-empting Bernanke’s similar guidance by nearly 2 and a half years. Way out  there on the transparency spectrum, the Swedish Riksbank, the Reserve Bank of New Zealand and the Norges Bank  publish forecasts (in the form of a chart) of their expectations for their respective policy rates, complete with 90% confidence intervals. Historically, smaller central banks have been the first to innovate in this regard,  and observing their behavior has allowed Bernanke et al to learn from both their successes and their mistakes. Over the years, I have been told that it is bad practice to extrapolate a trend blindly into the future, but it is interesting to ponder the possibility of Riksbank-type forecasts accompanying future FOMC press releases.

Implications of the Fed Reaction Function

The Fed’s reaction function, which I summarize as “we will not increase short-term rates until unemployment falls to 6.5%, so long as inflation remains near our 2% target” strikes me as quite problematic. My concern surrounds the level of unemployment that they have selected as their trigger. There has been much debate recently among macroeconomists regarding whether the financial crisis and its accompanying very long average periods of unemployment have increased America’s ‘natural’ (or structural) rate of unemployment. The Fed officially says no, while many others (including some Fed researchers) think that is has. Without hauling out the (fairly lengthy) argument for why, I am quite firmly in the latter camp. Therefore, I expect that the US economy will attain full-employment before the Fed recognizes it, and as a result, Fed policy will be behind the curve. This will give rise to wage-push inflationary pressures as the economy exceeds full-employment output. Given that the Fed’s baseline expectation for a rate hike remains at mid-2015, the time horizon for these pressures to emerge is late 2016 or into 2017. The Fed’s favorite measure for longer-term inflation expectations: the 5×5 year breakeven inflation rate (the market’s expectations for inflation over the 5 year period beginning 5 years from today) has hovered near multi-year highs since the December announcement. Too bad Bernanke wasn’t more explicit about the definition of “well-anchored ”.

5-year-BE1

Thankfully there is somewhat of a silver lining, at least so far as the Fed’s credibility is concerned: over this time horizon, the Fed will ultimately avoid unhealthy levels of inflation as a result of a serious deceleration in Chinese growth, and the significant fall in hard commodity prices which is sure to accompany such an event. But more on that in the next episode.

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