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.