“If I turn out to be particularly clear, you've probably misunderstood what I've said.”– Alan Greenspan
In recent decades, the Federal Reserve has become much more open. However, Fed communications have not always been received clearly by financial market participants. That has become problematic on a number of levels.
We’ve come a long way from the days when monetary policymaking was an obscure process and the central bank was viewed as a mysterious priesthood. Prior to 1994, the Fed did not even announce changes to the federal funds target rate. The Fed now issues a policy statement describing the economic outlook and the reasoning behind policy decisions. Detailed minutes are released three weeks after policy meetings. The Fed chair now conducts press conferences four times per year, explaining in some detail how decisions are reached and taking question from the press. And yet, market participants are often confused by the Fed, unsure of what the central bank is doing.
Former Fed chair Alan Greenspan was famous for obfuscation. By blowing verbal clouds of smoke, he often appeared to be intentionally vague, and that stance generally worked for the financial markets. Communications with the public began to get clearer during Greenspan’s tenure. Ben Bernanke, his successor, made communications a top priority. Where Greenspan was vague, Bernanke was crystal clear. However, Bernanke found that the message was not always getting across. Bernanke would often say something like “a, but possibly b” and market participants would hear the “a” part or the “b” part, but not put the pieces together. This was especially troublesome when the Fed exhausted conventional monetary policy (lowering rates close to zero). Unconventional policy (forward guidance, large-scale asset purchases) should not have been all that controversial, but to paraphrase Mark Twain, “a tweet by Sarah Palin can circle the globe in the time that Ben Bernanke is putting on his shoes.” The Fed Chair did a great job in explaining why the Fed was doing what it was doing and what the risks were, but that effort was often overshadowed by certain politicians forecasting hyperinflation and a worthless dollar. This matters a lot, as the Fed faces the prospects of “reform” from Congress.
“In determining the timing and size of future adjustments to the target range for the federal funds rate, the [FOMC] will assess realized and expected economic conditions relative to its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial and international developments.”
– April 27 FOMC statement
More open communications have also be an important goal during Janet Yellen’s tenure as Fed chair and she too has had some difficulty in getting the message across. Currently, the Fed’s main directive is that policy decisions will be data-dependent, centered on improvement in labor market conditions and the inflation outlook. However, it’s still going to be a judgement call. Fed policymakers will consider a wide range of economic information, including anecdotal information. Yet, data are bound to be mixed. How will the Fed weigh mixed economic signals? Officials will have their own views, and the Fed will have to balance those views as it tries to achieve a consensus policy stance. Certain Fed district banks (we’re looking at you, Philadelphia and Richmond) have been historically hawkish (inclined to raise rates early and more often). The Fed governors tend to be more pragmatic. The Fed’s Governors (five currently, with two nominees lingering in the Senate) dominate the voting district bank presidents and Chair Yellen dominates the governors. However, it’s not a dictatorship. Yellen, much like Ben Bernanke, is open to hearing other points of view and decisions are reached by consensus.
It’s certainly no secret that the Fed wants to normalize monetary policy. Exceptionally low levels of the overnight lending rate are not the norm. The question is how rapidly the Fed wants to get there. The policy risks are asymmetric. It will be much easier to correct course if the Fed finds that it raised rates too slowly (it merely would have to raise rates more rapidly). However, there are limited options if the Fed discovers that it has raised rates too quickly.
The Fed is currently replacing mortgage prepayments and maturing Treasuries by purchasing new securities. The end of this reinvestment policy was expected to be the first step in policy normalization under Bernanke, but the order has shifted under Yellen. In March, Yellen said this policy will continue “until normalization of the level of the federal funds rate is well under way.” Maintaining the reinvestment policy should provide some insurance against a possible future adverse shock to the economy. When the reinvestment policy ends, the size of the balance sheet should decline naturally over time.