Connect the Dots
How and what should the Federal Open Market Committee (FOMC) communicate to make monetary policy most effective? That is the question addressed by this year’s U.S. Monetary Policy Forum report (Language After Liftoff: Fed Communication Away from the Zero Lower Bound).
Over the past two decades, the FOMC has made enormous strides in promoting transparency. In sharp contrast to most of its previous history, the Fed now emphasizes that transparency enhances the effectiveness of monetary policy. Former Chairman Ben S. Bernanke’s hyperbole—“Monetary policy is 98% talk and 2% action”—is illustrative of the current attitude. And, the ways in which the FOMC communicates—from minutes and transcripts to press conferences, testimony, speeches, and staff papers—are now so broad, deep, and frequent that no single observer can absorb it all in a timely way.
Yet, central bank communication is a work in progress. And, as the new USMPF report argues, there remains scope for improvement. In our view, the simplest and most useful change that the authors recommend, and that the Fed could implement—immediately and without cost—is to “connect the dots:” that is, to link (while maintaining anonymity) the published interest rate forecasts of each FOMC participant that appear in the quarterly “dot plot” (found in the Summary of Economic Projections, or SEP) to that same person’s projections of inflation, unemployment, and economic growth.
To understand the argument for connecting the dots, start by recalling that monetary policy is transmitted to the economy through changes in financial conditions, broadly defined. These include the level of interest rates across the maturity spectrum; the prices, liquidity and volatility of assets (from riskless debt to junk bonds and equities and from commodities to foreign currencies); the ease with which new financial assets are created and sold; the supply of and non-price conditions imposed on credit; and so on. The response of financial conditions determines the ultimate impact of changes in monetary policy on economic activity and inflation.
Importantly, financial conditions are determined in financial markets by forward-looking participants. In addition to forming views about the future evolution of the economy and prices, these participants make judgments about the future stance of central bank policy. For example, long-term interest rates depend on future monetary policy decisions that determine the path of short-term interest rates and influence bond risk premia.
So, to the extent that market participants anticipate future central bank actions, their behavior will alter financial conditions and affect the economy long before the central bank acts. Indeed, when policymakers’ conditional reactions to events is understood, financial markets can amplify and speed the impact of policy in a fashion that helps stabilize the economy. Put differently, improved communication helps ensure that the response of financial markets to economic news conforms to the central bank’s eventual response.
Another way to think about it is that effective monetary policy communication reduces the importance of the frequency (or infrequency) of central bank policy meetings and actions. When fundamental news about the economy arrives, financial conditions anticipate the prospective central bank response, even if the next meeting is weeks or months away. That is, if the central bank’s reaction to news is perfectly understood, it is as if they were to meet and adjust policy every day.
The point is that central banks can limit economy-wide instability—the sort that creates undiversifiable, systematic risk—when they: (1) establish a policy framework consistent with minimizing such risk; and (2) make it easy to forecast their responses both to anticipated and unanticipated changes in economic conditions. Stabilizing the economy promotes saving, investment, and economic growth. In our view, the goal of limiting systematic risk—or at least not contributing to it(!)—constitutes a Hippocratic Oath for economic policymakers.
To a remarkable extent, the Fed has achieved the first goal. At the start of 2012, the FOMC announced a quantitative objective for inflation, and made clear that—over the long run—its actions are the key determinant of inflation, while nonmonetary factors govern the sustainable level of employment. This de facto inflation-targeting framework encourages financial market participants to anticipate that the FOMC will act to keep inflation low and stable, and employment close to its maximum sustainable level. The credibility of the Fed’s commitment to a long-term objective has kept inflation expectations reasonably stable in the face of enormous and persistent deflationary shocks since 2007. Had deflationary expectations taken hold—as they did in the early 1930s or in Japan in the 1990s—systematic risk in the U.S. economy would have been far higher.
But with respect to the second goal, there remains a bit of low-hanging fruit: helping market participants anticipate how the Fed will adjust its policy tool(s) in response to changes in economic and financial conditions (what is commonly known as its reaction function). Absent a large financial shock, the FOMC has made clear that inflation and unemployment (or economic growth) are the principal drivers of monetary policy. Yet, it is no simple task to quantify by how much the FOMC is likely to alter the target range for the federal funds rate as inflation and economic prospects evolve.
In part, this challenge may arise from a lack of FOMC consensus about how to react in various circumstances. The world is complex, and FOMC members appear uncomfortable with any formula that oversimplifies and diminishes the richness of their decision-making process. Indeed, this is one reason why Fed policymakers object to legislative requirements that they publicly benchmark policy against a simple policy rule (see, for example, the recent speech at NYU Stern by Federal Reserve Bank of San Francisco President John Williams regarding “Rules of Engagement”).
Moreover, while a consensus on a reaction function would help policymakers ensure that their decisions are consistent with a long-run strategy, reaching agreement at each meeting already presents sizable challenges for the Committee. Indeed, changing circumstances likely prompt individual FOMC members to alter their own reaction functions from time to time, changing the list of key drivers, the sensitivity of policy to each driver, and how much to “smooth” the policy rate adjustment over time when economic news arrives. (As we noted in a previous post on forward guidance, increased policy smoothing, or inertia, can be an optimal response in periods of elevated economic uncertainty.)
So, how can the FOMC improve its communication about a policy reaction function that—if it exists at all—is at best implicit? As the USMPF report highlights, the Committee already collects and publishes information from meeting participants that is useful in gauging how changes in the economic outlook are likely to affect the future course of policy. The authors exploited the median FOMC projections for growth, unemployment, and inflation that appear in each quarterly SEP. Using these data, they estimate several policy reaction functions in the form of Taylor rules that employ alternative measures of economic slack (from the unemployment and growth projections) to identify at each FOMC meeting either the policy target itself or the meeting-to-meeting change in the target. Some of these do appear useful in predicting future policy.
Of course, the median FOMC projection is not a Committee consensus. Indeed, the median projections for economic growth, inflation, unemployment, and the policy target may reflect the views of four different meeting participants! As a result, using only the quarterly SEP data that is currently published, there is no way to know whether these USMPF models of the median reaction function correspond to the views of any specific Fed Governor or Reserve Bank President. (Similarly, a recent Federal Reserve Bank of Cleveland commentary that focuses on private forecasters highlights dramatic differences both among their economic projections and their implicit policy reaction functions. The implication is that median estimates may contain very little useful information.)
The ambiguity arising from the SEP comes from the fact that readers cannot “connect the dots” from a projected policy rate path to a forecast of the economic fundamentals. Consequently, we have no idea whether a relatively high rate target reflects a member’s near-term economic projections (say, for strong growth, high inflation, or both), a judgment about the economy’s long-run capacity, or a preference for a tighter policy for any given economic prospect. If, as we believe, each FOMC participant is projecting the interest rate path needed to bring the inflation rate to 2 percent and output to potential (or unemployment to the natural rate) over the next few years, disclosing the links among their interest rate, inflation and economic projections would allow observers to estimate individual (but still anonymous) reaction functions and form a better understanding of the Committee’s behavior. While the Fed already compiles the necessary information, it currently discloses the links among the fundamental forecasts only when the transcripts of FOMC meetings are published five years later (see, for example, here).
The USMPF paper makes a thoughtful case for advancing (and broadening) this disclosure by including all the linked forecasts of economic fundamentals, along with the corresponding policy rate projections, with each quarterly SEP. To be sure, doing so will hardly revolutionize the Fed’s already transparent communications policy. But, to the extent that earlier disclosure helps financial market participants anticipate—and speed the economic impact of—monetary policy developments, it contributes to economic stability.
Perhaps more important, if the expectation of disclosure encourages FOMC meeting participants both to focus greater effort on their fundamental forecasts and to think about policy setting more as a long-run strategy (rather than as a repeated set of one-off meetings and short-term compromises), it also would reinforce policymakers’ Hippocratic oath: “We will not add to systematic risk.”