Thanks to my friend David Kotok to share this:
February 01, 2012
Bob Eisenbeis is Cumberland’s Chief Monetary Economist. Prior to joining Cumberland Advisors he was the Executive Vice President and Director of Research at the Federal Reserve Bank of Atlanta. Bob is presently a member of the U.S. Shadow Financial Regulatory Committee and the Financial Economist Roundtable. His bio is found at http://www.cumber.com. He may be reached at Bob.Eisenbeis@cumber.com.
A lot has already been written on the FOMC’s latest efforts to increase the transparency of its conduct of monetary policy. It has been a long, drawn-out, deliberate process that has transcended more than one Chairman. When William McChesney Martin was chairman, not even the FOMC was always privy to how policy was conducted. Martin and the manager of the Open Market Desk relied upon “tone and feel of the market” to determine policy until other FOMC members engineered a change in the procedures. Lack of transparency was the rule until Greenspan’s regime, when the Committee began to indicate publicly after its meeting whether it had actually changed its funds rate target. Before that a cottage industry of Fed watchers evolved and flourished by looking at what was happening in short-term money markets and divining whether policy had changed and by how much. That was a golden time for former Fed officials, but not so good for the economy.
Under Bernanke, sea changes have emerged as the Committee has begun to provide forward guidance, hold press conferences, and generally encourage members to try to clarify in public statements and speeches what the policies are. This last meeting saw another interesting step taken.
What have they done that is different, and more importantly what have and haven’t we learned about how policy is likely to evolve over the near term? I would suggest that the new transparency policy is less significant than some have suggested and is better viewed as a further evolution of what has been a continual and gradual process.
Let me make one observation before proceeding, based upon several years of having sat in on FOMC meetings. I observed the efforts of several different committees charged with addressing how better to communicate what the FOMC is doing and what the future course of policy might be. In each instance, the committees failed to ask or to address two important questions: Who is the audience, and what do they need to know? If there are multiple constituencies, then it is critical to determine whether “one-size-fits-all” statements are sufficient.
Clearly, there are at least two and most likely three distinct and important audiences: the general public, the markets, and the Congress. Since the Fed and FOMC are creatures of Congress and have to answer to that body if policy does not go right, it is important to be communicating effectively to that group as well as to the public and markets. It seems obvious that each of these constituencies may need different kinds of information to meet their needs for transparency, and hopefully these different needs will be recognized and addressed as the Committee’s transparency efforts continue to evolve.
For example, markets are fixated on what is going to happen in the shorter run and what short-term changes in policy might mean for asset positioning and the shape of the term structure. Markets are concerned about this week and this quarter and not yearly summary statistics. The general public is more likely to be concerned about how the Fed sees the present economy – what is the unemployment situation and what is likely to happen to inflation? What about Congress? Congress has given the FOMC statutory mandates concerning employment and inflation that are admittedly vague and subject to considerable interpretation.
During election years, for example, real GDP growth and employment and how the Fed is doing relative to its charge are of critical interest to politicians. Congressman Ron Paul has put these issues front and center, and other candidates have chimed in as well. I can’t remember an election season when so much attention has been given to the Fed, the value of the currency, the gold standard, and how well the FOMC has or has not performed. Some of it harkens back to William Jennings Bryan and the “cross of gold.” The amount of misinformation and simplistic rhetoric is evidence enough that there remains a significant communications problem in ensuring that the Congress understands what the Fed is doing and why.
Clearly, the informational needs of these disparate constituencies are not mutually exclusive; but we need to ask ourselves how well each has been served by the changes announced following last week’s FOMC meeting. Let us look first at what the FOMC did that was and was not new.
The Committee did several things, and some can’t really be viewed as expanding the transparency efforts. For example, the Committee reaffirmed and extended its policy of lengthening the maturity of its portfolio and reinvesting interest payments received and maturing principal of agency securities and Treasury holdings. This is not a new policy for this meeting, but rather is a continuation of its recent “operation twist” policy. Second, the Committee extended the time horizon over which it expected to hold the target Federal Funds rate between 0 and .25% from the middle of 2013 until late in 2014. Again, this is a continuation of existing communications efforts put in place previously to provide forward guidance to markets. It also suggested that these policies might be adjusted, if needed. Finally, the Chairman held a press conference to explain what was done and why. Again, nothing is new here.
But two things were done that did expand the FOMC’s communications policies. The first was the establishment of an explicit inflation target of 2%, but demurred from establishing an explicit unemployment target.
Delivering on an explicit inflation target is probably best viewed as an affirmation of what should have been fairly apparent from speeches and from the Committee’s longer-run quarterly inflation projections. For some years now, the Committee’s longer-run projections had always suggested that the Committee was aiming for an inflation outcome for PCE between 1.5 and 2.0. If you look at past projections you will see that the range has narrowed over time and the lower range has increased.
During Chairman Greenspan’s tenure, the Committee evolved a “preference” for PCE inflation between 1 and 2%. So what we have learned from the Committee’s most recent decision is that it will now be targeting a point estimate of 2% for inflation rather than a range. Moreover, this current Committee seems to have settled on a more dovish preference for inflation than previous Committees, whose members had expressed a preference for keeping inflation between 1 and 2%. Obviously, with inflation hovering close to the 1% lower bound for some while and with the Fed’s problem of not being able to lower its funds rate target below zero, this most likely conditioned the preference for a 2% target to preserve policy flexibility.
Three immediate questions now arise, and no clarification of them was provided, either in writing or in Chairman Bernanke’s post-FOMC press conference. First, what is the time horizon over which that 2% target will be pursued? Is it monthly, or a year or over some longer time horizon?
Second, how much of a deviation from the target will be tolerated before a policy move in either direction is likely to be forthcoming? Having a single percentage-point target is one thing, but it will be impossible to hit with any precision. Unless the Committee is prepared to react every time inflation moves off of 2%, that single point target has to imply a range or tolerance interval around 2%, which is as yet unspecified. The benefit of a range, like 1.5% to 2.5% for example, would normally suggest that the probability of a policy move increases the close observed inflation gets to the upper or lower bound. With a point target like 2%, however, it is now uncertain as to what the probabilities of policy moves are as observed inflation deviates from 2%. Regardless, the 2% target now implies that the Committee is more tolerant of inflation than it was under Greenspan, since the implicit range has been ratcheted upward.
Third, what are the likely policy tradeoffs when both unemployment and inflation deviate from their desired paths? The most important question in the current environment is, how much inflation overshoot will the Committee tolerate if unemployment remains undesirably high, before a policy move is triggered?
Now, let us consider the Committee’s logic for not putting forward a specific target for the unemployment rate. The reason given was that while “The inflation rate of the longer run is primarily determined by monetary policy…. The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market.”
What is the Committee really saying? To this observer, the Committee is confirming what seems to be the consensus among most contemporary economists. That is, the FOMC can’t have much if any influence over employment and that it will seek its own level if the overall economy is performing acceptably. In other words, the Committee has a statutory, mandated objective but monetary policy is not the appropriate tool to address it. Thus, there is little reason for the Committee to have that charge in the first place, and some in Congress have recently urged changing the FOMC’s mandate for that very reason. Having said that, it is interesting to note that the FOMC’s forecasts for the equilibrium unemployment rate range between 5% and 6%. This is really a squishy projection, especially since the rate was very close to or below 5% for several years before the financial crisis and is now substantially above even the upper bound of the range.
Ok, so far, aside from the explicit inflation target, little more has come from last week’s decision than a further evolution of the FOMC’s communications policy. But one thing the Committee did do that was very interesting was to release some of the detail on individual member’s forecasts.
The information released provided the distribution for each FOMC participant’s assumptions as to whether the Fed Funds rate would be increased this year and over each of the next four years. Most pundits are calling this a projection or a forecast, but that is not the case. It is an assumption by each FOMC participant about what he or she considers the appropriate path for policy over the forecast horizon.
The Committee also provided each participant’s assumption of what the prevailing rate would be at the end of each of the three years 2012-2014 and over the longer run. Notice that information on when rates might be changed covered two additional years (2015 and 2016) than information provided on the prevailing rate at the end of three years ending in 2014. Digesting this information suggests several interesting questions. For example, the Committee committed to keeping rates unchanged until near the end of 2014, yet six participants assumed that rates would increase this year and next. Another five thought rates would increase by the end of 2014. One can guess which three participants assumed the rate would increase this year. Indeed, President Plosser stated on January 30 that he was one of those three. Given past policy positions, it is likely that Presidents Fisher and Lacker (the latter is the only voting member among the three) were the other two. It certainly would be interesting to know what their forecasts for inflation, growth, and unemployment looked like, compared with those of other members of the Committee.
Moreover, five participants thought rates would increase in 2014, but how many thought those rate increases would come before the time period the Committee specified in its statement? Finally, the extreme differences in views among the participants are reflected in the fact that four thought the first rate increase would occur in 2015, and two not until 2016. That means that over a third of the participants thought the first rate increases were really far off, while another third assumed rates would increase before late 2014, the time span the Committee stated. So what did their forecasts for the other key variables look like? What we are likely looking at are wide differences in views about the prospects for unemployment versus inflation and differences in the tradeoffs between the two objectives. If the six participants who thought that rates would not increase until well after 2015 were all Board members and the President of the Federal Reserve Bank of New York, this would be a very significant piece of information, since they are all permanent voting members of the Committee and can thus hold out for their preferred policies, regardless of what the other Committee participants want.
Even more interesting is that six of the participants assumed that by the end of 2014 the Funds rate would be between 1.5% and 2.75%; and over the longer run rates would be between 4% and 4.5% (only one had rates below 4%). Given that six people thought rates would be still at 0-.25% by the end of 2014, the path they assume to get to 4% or higher must imply a rapid change in policy of more than 25 basis points at a clip. That policy path would seem to be substantially different from that assumed by participants expecting rates to be between 1.5 and 2.75 percent at the end of 2014. All of this matters critically to markets.
The wildly divergent views among the FOMC participants is very important and suggests that a lot of time and effort will be spent by market watchers and outsiders to determine who holds what views. Again, we have seen this already as President Plosser was pressed in his January 30 interview about his forecasts and policy preference. More of this is likely to come. Layer upon this the fact that we are looking at a changing Committee, because four members rotate off each year, and policy could swing significantly. The dynamics of Committee membership and rate assumptions introduce great uncertainty, not only over the shorter run but especially over the next few years.
How much have the disclosures helped the market? I would argue not much, since yearly rate information is not very informative when day-to-day and month-to-month variations can make or break portfolios. As for the other constituents, there is not much there to help them either, since the really important details about the meeting-to-meeting paths for rates and views of the economy, together with the tradeoffs between objectives, are where the rubber hits the road. Hopefully, the Committee will revisit and refine its transparency efforts as time goes on, but for now they have taken another modest step toward providing the transparency that the various interested parties really would like to see.
Bob Eisenbeis, Chief Monetary Economist
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