Last week’s decision by the Federal Reserve to provide a quantitative definition of price stability and the publication of the 17 Federal Open Market Committee members’ expectations of the Fed funds rate over the next few years aims at improving transparency and accountability of the central bank. It also raises several questions.
The first relates to the time horizon over which the Fed is supposed to achieve price stability, namely the long-run. This differs from most other central banks in advanced economies, where price stability is targeted over a horizon of two to three years. The reason for focusing on the medium term is that inflation forecasts over a longer period are not very reliable. Price movements 10 years from now will depend on factors that cannot be foreseen today and in any case are hardly affected by today’s policy decisions.
Monetary policy produces its effects with lags of one to three years. This is the period over which the central bank should be held accountable. Focusing over this time horizon also helps market participants. For instance, it’s not too difficult to anticipate a monetary policy tightening if a central bank publishes forecasts that show inflation rising above the stated objective for the next two to three years.
But if the objective of price stability is defined over the longer term, communication becomes more complex. In particular, the link between the inflation forecasts and the policy decision is unclear. What should market participants derive from a published inflation forecast above the two per cent target in the long run (but not necessarily over the next two years)? Should they expect a tightening to take place? And when? The long run is not a “policy-relevant” time horizon and thus has little value for those attempting to understand the central bank’s next moves.
The second question relates to the fact that the interest rate expectations formulated by the FOMC members are all conditional on the state of the US economy. If conditions change over time, the members will revise their forecasts at the next meeting. But for the market to understand this process, and to be able to continiously update its views, it needs to have some idea of the forecasting model used by each of the members. Without this, the task of Fed-watchers will become much more complicated. The suspicion may arise that the interest rate forecasts are ultimately dictated by the members’ short- term policy preferences, rather by than their ability to predict prices over the long-term.
Finally, while the concept of a conditional interest rate forecast is understood by market participants, it may not be by the public and politicians. This could lead to misunderstandings and recriminations. How will people react if, after having taken a decision (for example, take up a mortgage for a new house) on the basis of the Fed’s published expectation of unchanged interest rates until 2014, they find out that interest rates might rise earlier because the conditions underlying the central bank’s forecast have changed. Won’t they, and their elected representatives, blame the Fed for having induced them to take decisions that turned out to be more costly than expected? How easy would it be for the Fed to explain that the earlier interest rate forecast was conditional on assumptions that did not materialise and that people should have taken the forecast with more caution?
To be effective, central bank communication needs to be well understood not only by sophisticated market participants but also by the public. As they are currently designed, the new tools might turn out to be too complex, and risk creating confusion, for both groups. This could be exploited by those, in particular in Congress, who are looking for new excuses to undermine the independence of the Fed. This risk should not be underestimated.
The writer is a former member of the executive board of the European Central Bank and currently visiting scholar at Harvard’s Weatherhead Centre for International Affairs