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Should the Fed Be More Reserved?
When you can't say what you mean, stop talking.
Remember how Ben Bernanke’s Federal Reserve was supposed to be all about openness and transparency? Somehow he and his colleagues still gave the markets whiplash by talking about how monetary policy might change in the future. It’s certainly useful to have some idea of what the Fed’s officials are thinking. But if they’re lousy at making their points clearly, what else can they do?
When Bernanke took over as chairman, he emphasized transparency as the keystone of his approach to policy. He took a professorial and explanatory approach in his appearances before Congress, in contrast to the deliberately nebulous pronouncements of Alan Greenspan. He also changed the Fed’s disclosure process to share more of its data and publish the minutes of its meetings more quickly. And in January 2012, the Fed committed to holding inflation near 2 percent — its first-ever numerical target, suggested by Bernanke at his nomination hearing eight years ago.
Never before has the public had such a direct view into the making of monetary policy, in the United States or anywhere else. What we saw hasn’t always been pretty. The Fed’s governors and regional bank presidents have had some healthy debates about economic trends and ways of dealing with the recent slump. But they’ve also missed worrying signals of crisis and recession, worried about inflation that never arrived, and changed their minds several times about the use of their monetary tools.
More recently, their frank approach to communication has caused disruption in global financial markets and the economy. On June 19, Bernanke gave a press conference in which he seemed to hint that the Fed would stop buying assets in financial markets, putting an end to its "credit easing" strategy, and markets everywhere tumbled. But within a week, other Fed officials were pouring cold water on the notion that the policy would change anytime soon, or at least before the economy appeared much stronger. It took weeks, however, before the genie was back in the bottle and the markets were calm.
The media has had a field day with all of this, of course, raising questions about the overall value of the new transparency. Confidence in the Fed, whose officials already suffer regular attacks from Republicans in Congress, may be eroding; seeing the inside of the sausage factory doesn’t necessarily make the end product more appetizing. On the other hand, the public is now getting information about the economy sooner than it did before.
In fact, the true value of transparency may be in knowing a bit more about how the Fed governors do their job: what data they follow, what they think is important, what triggers would lead to what decisions. This information allows economists, investors, and anyone else to critique the Fed’s thinking. If the governors are missing something, the public can try to let them know.
Yet there’s still the problem of people misunderstanding the Fed, particularly when it talks about the future.
Bernanke’s attempt to describe the coming direction of American monetary policy actually misled millions of people, making it just as bad, if not worse, than Greenspan’s riddles. The day before his speech, the interest rate on the 10-year Treasury was 2.2 percent; a week later, it was 2.6 percent, even though the Fed’s officials tried to reassure investors that they would continue to inject credit into the markets. There’s less risk of this happening when the Fed discloses the minutes of its meetings or tries to explain past and current policy; in these cases, the connections between words and deeds are clearer.
If the Fed wants to telegraph its plans — and recent evidence suggests it does, to avoid causing disruptions and volatility in the markets — there are better ways. One possibility is to automate policy by setting plans of action for a series of circumstances — saying that when X happens, the Fed will do Y. For example, Narayana Kocherlakota, president of the Minneapolis Fed, suggested last year that the Fed keep short-term interest rates low until the unemployment rate fell to 5.5 percent, unless inflation began to rise.
Another option is simply to eliminate opportunities to change policy. The Fed’s Federal Open Market Committee, which makes decisions on interest rates, is required by law to meet four times a year. Lately, its practice has been to meet eight times a year, plus the occasional emergency meeting. What better way to signal that a policy will remain in place, barring anything urgent, than to cancel the committee’s meetings for a few months?
A third alternative that could work in conjunction with (or instead of) either of the first two would be to attach some kind of consequences to a failure to carry out stated policy. In other words, a Fed chair could promise to resign if the Fed did not keep the target for short-term interest rates fixed for the next nine months, or did not adhere to a rule like the one Kocherlakota proposed. This threat might not be credible, though, if a resignation would disrupt markets even more than changing policy.
All of these mechanisms are designed to help the Fed commit itself to policy in the future. In each case, the policy needs to be specified in a way that’s clear and verifiable; the commitment is no good if no one can tell if the Fed followed through. Bernanke is an expert economist who is undoubtedly well aware of how such mechanisms are structured. He has six more months to save the Fed from mistakes like the one he made.