The Fed Whisperer, John Hilsenrath, had a great insidery article yesterday about forward guidance, and about the Fed’s ability — or lack thereof — to effectively signal its future actions. And it was timely, too, coming as it did a day before the official nomination of Janet Yellen as the new Fed chair.
The job that Yellen inherits is very different from the job which faced all of her predecessors. They focused almost exclusively on the question of where to set the Fed funds rate; that’s a non-issue for Yellen, who is certainly going to keep that rate at zero for the foreseeable future. Instead, Yellen has two other tools at her disposal. One is QE: the Fed can continue to pump money into the economy for as long as it likes, although no one on the committee loves the idea of doing so indefinitely. And the second is forward guidance, or what is sometimes called “federal open mouth operations”: the ability of the Fed to set expectations by being very clear about what it intends to do in the future.
As Hilsenrath details, the Fed’s new commitment to transparency — something Yellen strongly believes in — has not gone entirely smoothly. As Fed governor Jeremy Stein said in a speech last month, there’s clear “room for improvement” when it comes to the Fed acting transparently and predictably.
The problem is that transparency and predictability are incompatible goals. Look at the minutes of the September FOMC meeting, which were released today: they reveal a tortured meeting, spread over two days, with more than its fair share of meta-worries about desirable and undesirable feedback loops between the markets, the Fed’s statement, and the minutes themselves. Frankly, the more transparent the Fed is, at times like this, the less predictable it becomes.
This is one area where I think that Yellen could be a real improvement over Bernanke. Think of Fed communication as starting with the studied opacity of Volcker and Greenspan, who once famously told reporters that “if I seem unduly clear to you, you must have misunderstood what I said”. As Binyamin Appelbaum says, central bankers historically have “regarded secrecy as a virtue and obfuscation as a prized technique”.
The Fed then evolved, as serious academic work managed to find strong evidence for the idea that transparent communication can and should be an important part of monetary policy. This was one of the great innovations of the Bernanke era: an unprecedented degree of specificity about how the Fed intended to behave in the future.
The problem is that the Fed and the markets both conceived of the forward guidance in terms of what economists might call the “stylized fact” that the Fed is a single actor making a single decision. There is a series of monetary-policy actions that the Fed is going to take in the future, and everybody started behaving as though (a) the FOMC had a pretty good idea what it was going to do; and that (b) the only question was how much leg the FOMC would show, in terms of revealing what it knew.
In reality, however, the tail soon started wagging the dog: when the Fed announced that it would keep interest rates at zero until at least mid-2015, for instance, that was not a simple expression of a decision which they had already made internally. Instead, the FOMC came to the conclusion that the announcement, in and of itself, would have a desired effect on economic conditions, and therefore said something which was carefully calibrated to have that specific effect (while also being consistent with what they thought they would probably want to do in terms of interest rates).
This was where tensions started setting in: it’s one thing for a Fed chairman to rally his FOMC troops and get them all to agree on a certain course of action at a certain meeting. It’s another thing entirely to try to get those troops to agree to a future course of action, stretching out as far as mid-2015, despite the fact that no one really knows what the economy is going to look like then. Promises can be broken, of course. But if you’re trying to build consensus, then the best way to do so is always to keep things narrow, rather than asking people to make broad, long-lasting commitments.
On top of that you have the fact that QE is an unproven experiment — and one which is pretty explicitly opposed by various FOMC members, especially some of the regional bank presidents. Making promises about the future of QE is dangerous, because those promises will be very hard to keep — but then again, not making any promises is also dangerous, since it results in markets throwing around terms like “QE infinity” or “QEternity”. And that’s a message the Fed very clearly does not want to send.
Enter Janet Yellen — someone who’s incredibly good at economic forecasting and academic analysis, and who is (I think) more comfortable with tension and conflict than Bernanke. Yellen has often been in the minority on the FOMC, and nearly always, when she has been in the minority, she was ultimately proved correct. She has far more FOMC experience than Bernanke did, when he became Fed chair — which means that she’s deeply familiar with the kind of personalities who populate the board, the range of opinions they hold, and the degree to which the chairman can nudge those opinions in a certain direction.
I suspect that when Yellen gives her post-meeting press conferences, we’re going to see something very different from what we’ve been used to with Bernanke. The current chair is patient, avuncular, friendly, eager to help people understand what he’s saying. He has a specific message, and he wants to get that message across as clearly as he can. Yellen, by contrast, is going to be more scripted, more empirical — and, I hope, more honest about the fact that the FOMC is a diverse group of people, with a range of opinions. Markets are naturally comfortable with probability distributions: they don’t need to be told with great specificity exactly what is going to happen.
What I’d like to see from Yellen is less of an attempt to artificially move markets by saying the right words at the right time, and more of an attempt to be honest and clear about the full range of opinions on the FOMC. Where Bernanke always just attempted to get across a single consensus view, Yellen should instead be more open about the full spectrum of opinions on the FOMC, and how that spectrum ultimately ended up being reduced to a consensus about what to do and say.
We live in a world where both the legislative and the judicial branches of government are racked with very open dissent — and yet where the Fed likes to pretend that it somehow manages to always rise above such things. It doesn’t; it can’t; it shouldn’t even really aspire to doing so. The most effective communication is honest communication: if Yellen can be open about disagreements within the FOMC, then that will have three positive long-term effects. Firstly, it will make market misunderstandings less likely, since there will be less of a feeling of “you said you would do this, but then you did that”. Secondly, it will give the FOMC more credibility in terms of the committee binding itself to future actions: if Yellen can show that the full spectrum of opinion falls in a certain range, then the market will be more comfortable expecting that outcome. And thirdly, it will allow Yellen to be an effective chairman even in the face of certain future dissents. She could even be an effective chairman if she found herself in the minority, once or twice — something which could never be said about Greenspan or Bernanke.
Yellen gets on very well with ultra-hawkish FOMC members: she should make that her not-so-secret superpower. If she can effectively represent the views of someone like Richard Fisher when she gives her press conferences, she will effectively move the markets from a naive expectation that Bernanke will simply tell them what he’s going to do, to a much more effective and sophisticated expectations that Yellen will be genuinely open about the full range of views on the committee. Which would be a genuine and important improvement.