In search of policy options, Fed digs into recycling bin

December 2, 2011

Since the 2008 failures of Bear Stearns, Lehman Brothers and American Insurance Group, the U.S. Federal Reserve has reached deep into unconventional territory for ways to coax the economy out of its deepest slide since the Great Depression, slashing interest rates to a shade above nothing and buying trillions of dollars of long-term securities.

Now it appears the U.S. central bank is diving for new ideas in its own dumpster – or recycling bin, as the case may be. As Fed officials vet a range of communications options that could provide more certainty to markets about the Fed’s policy intentions, they are warming to the idea of providing forecasts for short-term interest rates.

Doing so, some central bankers believe, would give markets a clearer idea of the Fed’s intentions, and could head off a recovery-choking jump in rates if investors start betting on tighter monetary policy before the Fed believes such tightening is warranted.

The idea is not new, and has been adopted by three central banks globally with some success. What has been largely forgotten is that the Fed itself considered, and then rejected, just such an approach four years ago.

The U.S. central bank already publishes some forecasts. Since November 2007, it has provided a quarterly summary of projections by Fed officials for a range of economic indicators, including inflation and unemployment. In the debate leading up to that decision, Fed officials also considered releasing the expected policy rate paths that underlie their economic projections. In a January 2008 speech, then Vice Chair Donald Kohn explained why the central bank’s policy-setting committee dumped the idea:

Specifically, it worried about a tendency for the public to infer more of a commitment to following the implied path than would be appropriate for good policy. In that circumstance, deviating from the path would risk market instability, and concerns about such dynamic responses would complicate already difficult policy choices. To be sure, over time, market participants might learn how little weight they should give any published average of “appropriate” policies, but the learning process could take time and be costly, and we would not be assured of a successful outcome.

In other words, Fed officials were fearful that markets would see statements about the future path of policy as commitments to action rather than projections based on current information and subject to change.

In a paper published a few weeks after Kohn’s speech, San Francisco Fed economist (and now chief researcher) Glenn Rudebusch sounded skeptical. Noting that central bank chatter about the future of interest rates was “one of the strongest central banking taboos,” Rudebusch suggested that central banks need not be so self-censoring.

Given the sophistication of the financial system, it may seem hard to accept claims about the inevitable breakdown of communication between central banks and financial markets. Indeed, in practice, financial markets appear to have appreciated the central bank interest rate forecasts provided in New Zealand, Norway, and Sweden and understood their conditional nature.

While nodding to  fears of the “black box” relationship between information and market pricing, “its potential for investor herding behavior, information cascades, multiple equilibria, and other problems,” Rudebusch went on to cite research, by himself and the regional Fed bank’s head research director at the time, that supports central bank decisions to, in their words, “reveal the secrets of the temple.” That report concluded that the publication of interest rate projections “usually, though not always, better aligns the expectations of the public and the central bank and helps the central bank achieve its policy goals.”

Kohn retired from the Fed last year, to be replaced by Janet Yellen, who was head of the San Francisco Fed when Rudebusch published that paper. Yellen now chairs a subcommittee, formed in July, that is examining communications changes including the possibility of publishing rate forecasts.

And Rudebusch’s co-author? That would be Yellen’s successor as San Francisco Fed chief, whose turn to vote on the Fed’s policy-setting panel comes up next year: John Williams. Sometimes the recycling bin yields useful secrets.


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