Toward an Even More Transparent Fed

January 23, 2012
Monty Hall, of Let’s Make a Deal fame, aimed for suspense, but he knew that a little transparency could add to the tension of a game show. So he told contestants what prize was behind the winning door, but not which door it was. As they selected among the three doors, anxious contestants provided titillation for TV voyeurs. [Unintentionally, Monty provided a great lesson in probability: See herewhy it’s optimal for a contestant to switch the door selection after Monty (raising the suspense) reveals that an unselected door does not contain the prize.]Monetary policy should not be designed to heighten suspense, nor should it be aimed at voyeurs. Yet, as central bankers around the world now affirm, transparency usually is desirable because it makes policy more effective.

If policymakers have a clear objective – such as anchoring inflation expectations – transparency can foster the private adjustments necessary to secure the policy goal. When households and firms are able to anticipate how policymakers will react to future developments, they can adjust their behavior quickly, even in the face of surprises. Similarly, rapid adjustment of financial conditions can speed policy’s impact. Because transparency makes policymakers more easily accountable, it also enhances their credibility. And it helps secure their independence, which is not feasible in a democratic society without accountability.Reflecting this wisdom, the Federal Reserve has lifted the veil on monetary policy over the past two decades. Prior to 1994, the Federal Open Market Committee (FOMC) did not even announce if it had altered policy. A priesthood of bond market experts had to divine the policy signal from the noise of daily open market operations, most of which had nothing to do with policy setting. This complex process could take weeks, and was aimed to conceal, rather than reveal. It incarnated the secretive motto of Montagu Norman, Governor of the Bank of England from 1920 to 1944: “Never explain, never apologize.”

Since then, the FOMC has come a very long way. In addition to announcing policy changes (or the lack of change), it provides in-depth analysis of the factors that are expected to drive policy going forward and identifies key risks. Since 2009, it has published a quarterly summary of the individual economic and inflation forecasts of FOMC members. And it provides considerable guidance about future policy plans. Consider its December statement: “The Committee […] anticipates that economic conditions – including low rates of resource utilization and a subdued outlook for inflation over the medium run – are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” Governor Norman must be turning over in his grave.

Around the world, central bank communications is a work in progress, as policymakers figure out how to turn the goal of transparency into practice. Some central banks – particularly in small economies – go further than the Fed. Sweden’s Riksbank, for example, publishes a common economic forecast (currently out to 2014) and a common forecast for the policy interest rate. The members of its board can and do dissent, and state openly their alternative projections. This information allows observers to understand clearly how policy is likely to evolve in the absence of economic surprises. The Riksbank (along with the central banks of Norway and New Zealand) currently sets the gold standard for transparency.

To its credit, the Bernanke FOMC continues to evolve in this direction. On January 25, for the first time, the FOMC will publish some details about individual FOMC members’ projections of the policy rate (you can find the template and an explanation here). Again, the goal is “to help the public better understand the Committee’s monetary policy decisions and the ways in which those decisions depend on members’ assessments of economic and financial conditions.”

The move should certainly be welcomed. What might we learn? It depends on precisely how much detail will be revealed. Suppose that the data is summarized in the same way as the economic and inflation projections have been. We could learn, for example, what FOMC members typically see as an appropriate federal funds rate in the “longer run,” presumably when the economy has settled down to a steady growth path. Because we already know (see the November 2011 projection) that the typical FOMC member views the “longer run” inflation rate to be in the range of 1.7 percent to 2.0 percent, we could gain some insight into what the typical FOMC member sees as the equilibrium real interest rate (the gap between the nominal interest rate and the expected inflation rate over the long run). Judgments about this rate can be an important component of stability-oriented monetary policy, and could influence long-run interest rate expectations in U.S. markets.

The FOMC’s interest rate projection template also includes some detail on when policymakers view the appropriate timing for the first policy rate hike from the current zero to 0.25% range. Accordingly, we will learn how widely these views on policy timing vary from the FOMC’s explicit forward policy guidance (“at least until mid-2013”). This news could get the most press attention, even though it may be of limited long-run importance.

What will we not be able to discern? As Monty Hall might have said, we still won’t know what’s behind all the policy doors: namely, the central bank’s “reaction function.” Such a reaction function would clarify both how policy is expected to evolve under a baseline economic scenario, and how the policy path would respond to economic surprises.

Recall that FOMC members will be specifying policy paths appropriate to their own individual economic projections. If the FOMC merely summarizes this data as before, the important link between a member’s policy rate projection and economic projection would be lost. Absent a supplementary disclosure by individual FOMC members (say, in public speeches), it may be difficult to judge how the FOMC majority associates an appropriate policy path with a particular economic outlook. That would mean considerably less information than the Rikbank’s consensus forecasts (and specific dissents) provide. It also would do little to make clear how economic surprises would affect the FOMC majority’s plans.

Ultimately, monetary policy transparency means revealing the Committee’s collective reaction function. To be sure, this is extremely complex. It is not feasible to show how policy would react to every eventuality. It also may not be feasible for the Committee to form a reliable consensus about the future policy path (especially when it lacks a strong consensus on current policy). Even where a consensus exists, it may be difficult to communicate in a simple, succinct fashion. The more a central bank aims at transparency, the greater the risks from miscommunication. In particular, policymakers need to guard against misperceptions that their interest rate projections represent unintended policy pre-commitments.

So what knowledge would be most helpful for the FOMC to reveal? Two issues come to mind. First, how do FOMC members make short-run trade-offs between their key goals of price stability and maximum sustainable employment? [In the jargon of monetary policy analysis, transparent policymakers should specify quantitatively how the “loss functions” that define their preferences weigh temporary deviations from these objectives.] And second, how do they model (forecast) the economy, including its response to policy changes? Addressing these matters could be instructive for the Committee, and might even help over time to forge a broader consensus.

Given the FOMC’s extraordinary progress over the years, it is no longer difficult to imagine policymakers eventually approaching this level of transparency. Doing so likely would, as most policymakers avow, make policy more effective. No less important, it also could help to reduce dangerous threats to the Fed’s independence from politicians who still (incorrectly) view the FOMC as a committee of Montagu Norman’s. If so, when we look back from a future vantage point at Ben Bernanke’s years as Fed Chairman, the FOMC’s continued shift toward transparency may be seen as his greatest legacy.

Posted by Dave Backus for Kim Schoenholtz

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