A WSJ article of Monday, December 5th reported on the latest thinking within the Federal Reserve as to how to improve the clarity of its communications policies, which will be the subject of discussions at the upcoming FOMC meeting on December 13.
The appropriateness of leaking details of material to be discussed at an upcoming FOMC meeting is itself an issue that deserves scrutiny, since the agenda is not available in advance and the substance is covered by confidentiality rules of the FOMC. The only purpose may be to launch trial balloons to see what additional reactions might be garnered to better inform the discussion that will actually take place. Assuming that is the objective, here goes.
What is the Fed considering? The article states there are two objectives in improving the quality of the Fed’s communications. One is to make clear what the FOMC’s specific goals are for inflation and employment. The second, and the one that deserves the more considered discussion, is to lay out the interest-rate strategy to be pursued to achieve these goals. What is revealing about the WSJ article is that consideration is being given to providing more specific information on the future path for interest rates, in an attempt to better inform markets and reduce uncertainty.
Where is the FOMC coming from in attempting to be more specific about its objectives? First of all, let us be up front about a couple of issues. Notwithstanding the legal mandate charging the Fed with both an inflation objective and an employment objective, the research literature seems fairly settled that Fed can actually only affect the long run rate of inflation. If this is true, then putting forth a goal for employment that it can't expect to achieve with monetary policy presents a conundrum in itself. Second, the FOMC now publishes its short- and intermediate-term forecasts for the rate of inflation, growth, and employment, consistent with its longer-run objectives. Thus, it is not clear that more is to be gained on that front. Finally, being specific about the future path for the policy rate may in fact do more harm than good and create more uncertainty than it resolves. These latter two issues are discussed in a bit more detail below.
Putting specific numbers on long-run employment and growth is plagued with two problems. Economic growth depends critically upon the rate of change in productivity, which has proved to be both variable and difficult to measure, especially in the short run. Similarly, unemployment is dependent upon composition of the labor force, its geographical mobility, factor productivity, and educational level, all of which vary over time. Under these circumstances, doing more than what is currently published in the forecasts only engenders additional debate and invites additional political influence that could threaten the Fed’s policy independence, when its views of longer-run growth and employment prospects differ from what politicians may desire.
The assumed benefits of being specific about the FOMC’s projected policy path are rooted in contemporary macroeconomic theory. The theory relies upon inferences drawn from very simplified, abstract models in which a “credible commitment” by a policy maker for the path of future policy can be shown to achieve better economic performance than when that policy path is uncertain. The problem is that the models are overly simplistic and depend upon assumptions about the ability to deliver on policy commitments that might not be appropriate as the structure of the economy evolves and experiences shocks that were unanticipated. In the real world, putting forth a path for the policy rate may create conflicts and tensions between the need to change the path for policy reasons, as distinct from the desire to deliver on a previous policy commitment to maintain credibility. The unintended consequence of changing policy that deviates from a previous commitment would surely be to create market uncertainty about the ability to rely upon future commitments, thus creating more uncertainty when the intent is to reduce it.
Consider the following. The economic policy literature posits that policy makers have specific longer-run goals for the economy. In this case, we are talking about long-run inflation and employment. They have intermediate targets for policy as a way to get to those longer-run goals. And finally, they have policy instruments that can be manipulated to affect the targets, which leads ultimately achieving the long-run goals.
This well-accepted literature also clearly states that policy makers need to have a policy instrument to manipulate for each goal they set. If, for example, the central bank has only an inflation objective, as the ECB does, then it only needs one instrument, the interest rate. If, as in the case of the FOMC, it has two mandated goals, such as inflation and employment, then it needs two policy instruments. But the FOMC has only one instrument, the Federal Funds rate. Thus, the FOMC must set the Federal Funds rate to achieve two goals, which sometimes may, as in the present case, be inconsistent with each other. Everyone would agree that the present rate of inflation is probably higher than the long run-objective (just look at the most recent FOMC forecasts), while unemployment is undesirably high.
This now introduces a critical policy complication. When there is a mismatch between the number of policy instruments and goals, it is impossible for the FOMC to commit to a path for interest rates that will be credible and that markets can rely upon. In the current situation the target Fed Funds rate is essentially zero, but inflation is higher than desired and unemployment is too high. For the FOMC’s policy-rate objective to be achieved, inflation must be curtailed or at worst remain constant, and the unemployment rate must decline. At some point, however, inflation will begin to accelerate if policy is too accommodative, can’t be sustained and requires a calibrated adjustment that can’t be perfectly predicted. This means that the Fed Funds rate will have to deviate from its announced path, and suddenly policy commitment vanishes. Investors and market makers who took positions based upon belief that the announced path would be followed will suddenly be burned, and credibility will evaporate.
The best that policy makers can do when faced with an evolving economy in which the underlying structure is changing is to make what economists call a state-contingent statement. That is, "If the economy evolves according to our forecast, then here is the path for the Federal Funds rate.” The problem then becomes trying to discern how much the key variables can or will vary from their predicted paths before a change in policy will be required. In short, it will be extremely risky for the market to regard any commitment to a policy path as credible.
What’s the saying? “Fool me once, shame on you; fool me twice, shame on me”? Those within the FOMC who are skeptical about the wisdom of doing more than revealing the expected path for the economy under assumed but undisclosed and appropriate policy are right. A better first step would simply be to expand the practice of providing quarterly forecasts to eight times a year at the conclusion of each FOMC meeting and holding a press conference to explain the forecasts.
