The Federal Reserve recently announced plans to publicize its interest rate expectations. The new approach, according to the Fed, should give investors and businesses a more reliable basis on which to plan. The Fed argues further that people, acting on those plans, will enable monetary policy to have a prompter and more thorough impact on longer-term bond yields and on the overall economy. Reasonable as all this sounds, matters may not go quite as smoothly as the Fed seems to think. On the contrary, the new open approach could cause more harm and more confusion than the former secrecy did.
The crux of the problem lies in the very real possibility that the Fed will find it impossible to stick to its stated interest rate expectations. Though the Fed directly controls short-term rates, it sets them to achieve some anticipated economic and financial effect. Since things seldom work precisely to plan, the Fed frequently has to adjust its rate policy as conditions deviate from expectations. Sometimes, unanticipated economic shocks force the Fed to reappraise its policy. Policy makers failed, for instance, to anticipate either the 2008-09 financial crisis or Europe’s sovereign debt problems. In less dramatic settings, such midcourse changes in rate policy simply acknowledge that the economy or inflation, for instance, have responded faster or slower than expected. A sluggish economic response to monetary easing, for instance, would force the Fed to keep rates lower for longer than it had planned. Stubborn inflation might force policy makers to keep interest rates higher for longer than they had planned.
When the Fed kept its rate expectations under wraps and people could only guess about rate directions, reactions to policy adjustments had built-in moderators. Some investors and businesses who expected a moderate Fed might have to shift their plans radically in one direction on the news of a midcourse correction. Others, who might have expected a more aggressive Fed, would respond in the opposite way. But with full disclosure from the Fed, there would be less of this bracketing of possibilities. Investors and business people might very well proceed as if the Fed’s rate projections were immutable, instead of contingent on unfolding conditions, and plan as if the future really were definite. Then, when the inevitable midcourse policy corrections occur, all would react in the same way, leading to much more severe economic and financial disruptions than would otherwise have occurred.
Unless Chairman Bernanke and his fellow monetary policy makers intend to develop superhuman forecasting abilities, the Fed will need to guard against the potential of such severe disruptions by warning people that reality might well deviate from the stated course. But by telling investors and business people in this way to treat the published expectations with caution, the Fed would also make them reluctant to plan as definitely and as boldly as the Fed recently said it wants. If, in contrast, the Fed, to encourage aggressive planning, fails to issue such warnings, then it would greatly increase the risk of severe market and economic disruptions each time it has to make midcourse rate corrections. This decision for transparency, then, seems poised either to defeat its own purpose or invite dangerous misunderstandings. Chairman Bernanke might do well simply to say less.
Milton Ezrati is senior economist and market strategist for Lord Abbett & Co. and an affiliate of the Center for the Study of Human Capital and Economic Growth at the State University of New York at Buffalo.