The Fed Needs to Get Its Story Straight
Published by Foreign Policy
© Foreign Policy
The Federal Reserve has a messaging problem. Having repeatedly prepared the world for an interest rate rise they suggested was around the corner, policymakers at the US central bank are now bending over backwards to attempt another graceful about-face. It's not working.
The mismanagement of central bank communications threatens the effectiveness of US interest rate policy, present and future.
The Fed's communications challenge is not trivial. The federal funds rate, which governs the cost of lending between banks and serves as a benchmark for the whole economy, has stood at a zero to 0.25 percent range since December 2008, during the depth of the financial crisis. Officials would like to give markets and the public time to adjust to what would be the first rise in official borrowing costs in nearly a decade. But in attempting to do so, American central bankers have bungled the message, leading to confusion among investors and undue market volatility. It's a problem that can be fixed if only the central bank is willing to learn from recent mistakes.
New York Fed President William C. Dudley was the latest recanter. Having ceaselessly argued the economy was strong enough for rate hikes this year, the influential Dudley told an Italian newspaper that fresh concerns about global growth make it too soon to consider a Fed rate hike. "The situation changed over the last few months," he said.
In August, just over a month before the Fed's September meeting, Atlanta Fed President Dennis Lockhart said in an interview that he thought the bar would be very high for the Fed not to move. He is seen as a bellwether on the policy-setting Federal Open Market Committee (FOMC). The data didn't change all that much in the period that followed, despite some market volatility. Yet the Fed decided to hold fire on tightening monetary conditions once again, this time citing uncertainty about the slowdown in China's economy, the world's second largest.
Importantly, Janet Yellen, chairwoman of the Federal Reserve, and other top board governors spoke little in the run-up to the crucial September meeting. Vice Chairman Stanley Fischer did give a couple of media appearances. But he shifted awkwardly from emphasizing weak inflation—and therefore an inclination not to move—to focusing on the cumulative strength of the economy, and thus the need to get rates higher. Almost three weeks before the September meeting, he told CNBC "it's early to tell" whether the Fed should raise rates on that occasion.
Confused? So were the markets. Investors headed into the meeting facing an unusual degree of uncertainty about the outcome.
Then, shortly after their September 17 decision to leave rates on hold, policymakers were again out in full force reassuring investors that borrowing costs would indeed be going up before the end of the year. "Given the progress we've made and continue to make on our goals, I view the next appropriate step as gradually raising interest rates, most likely starting sometime later this year," said John Williams, president of the San Francisco Fed, just two days after the meeting. As Adam Posen, president of the Peterson Institute for International Economics, tweeted in response to a packed line up of Fed speakers: "This is no way to run a railroad. All FOMC voters should speak but should coordinate, not fight for oxygen."
Why does this matter? In recent years, with interest rates already at zero, Fed communications have become an important factor not just in conveying policy but in actually pushing borrowing costs lower. Because interest rates are already at zero, the Fed's hints about the future path of rates are just as important a compass for guiding financial market traffic as rates are themselves. In his new book, The Courage to Act, former Fed Chairman Ben Bernanke argues policymakers' speeches "aren't just about policy; they are policy tools."
In that light, the mismanagement of central bank communications threatens the effectiveness of US interest rate policy, present and future. So it should worry more than Wall Street traders trying to guess the exact date of the central bank's first tightening move. And that crowd of supposedly sophisticated investors certainly isn't believing the Fed's hype. Despite official promises, the futures markets indicate investors now see the Fed waiting until at least early next year before it starts to gradually close the monetary spigot.
Given the muddled message, it's clear Fed communications could use some smoothing. But what is a central bank striving for greater openness to do?
In an effort to break an old pattern—epitomized by ex-Chairman Alan Greenspan—of casting the central bank chief as an omniscient demi-god, Bernanke sought to develop a more collegiate environment where dissenting voices were encouraged. Yellen has largely embraced and extended Bernanke's approach.
It worked. Perhaps too well. Many Fed watchers now complain that good intentions have devolved into a cacophony of often-contradictory statements that do more to obfuscate than to clarify. But all is not lost. A few changes to the Fed's communications approach could go a long way toward restoring some coherence to the central bank's message.
First, the Fed's Board of Governors, particularly chairwoman Janet Yellen, should make more frequent and timely public pronouncements. The Fed is composed of a Washington-based board of seven governors and 12 regional banks, each led by its own president. Together, they form the 12-member FOMC, though presidents of districts other than New York only get a rotating policy vote, and thus considerably less say over interest rate policy.
However, the Fed board's institutional inertia means the more powerful board governors often speak less frequently and less loudly than the less influential but more vocal presidents of regional Fed banks. This exaggerates the impression of disagreement within the committee, arguably diluting the effect of new stimulus policies not long after they are unveiled.
The Fed seems, belatedly, to have become attuned to this error of omission, trotting out governors Lael Brainard and Daniel Tarullo in back-to-back appearances this month. Both offered the same cautious message about the need to wait for further confirmation of economic strength before lifting rates from zero.
A second way to elevate the board's public visibility more systematically would be to have Yellen hold press conferences at every policy meeting, rather than just quarterly. This would also solve another problem, which is that no one believes the Fed would take serious actions at a meeting that doesn't have a press conference despite Yellen's assurances that every meeting is "live." That's because investors reckon Yellen would prefer to explain a big policy decision publicly when the committee makes one. The Fed has said it could set up a teleconference with reporters on an ad hoc basis. Again, Wall Street believes the logistical issues this poses just aren't worth the risk—the mere announcement of a teleconference would itself spook markets.
Third, board governors and Yellen herself might consider talking to reporters after they give speeches, like the regional bank presidents do. The board's communications team currently forbids this but, in its effort to guard the governors' pronouncements tightly, it inadvertently empowers a dissenting but irrelevant minority.
Fourth, the Fed needs to follow its own rules. The central bank made a concerted effort starting late last year to divorce its "forward guidance" on interest rates, what it tells markets about the expected future path of policy, from specific calendar dates. Yet officials in their public statements keep falling into the trap of trying to offer time forecasts for the first rate hike. That leads to too many takebacks, which in turn hinders the central bank's credibility. It also opens the institution to political scrutiny from Republicans who, backed by economists like John Taylor, Stanford University professor and former senior Treasury official, argue the Fed needs to follow more stringent policy rules in its decision-making about where to set interest rates.
Lastly, the Fed has to stop the cheerleading. Because of the important roles business and consumer confidence play in fostering economic growth, central bank officials often find themselves taking too-rosy a view of the economic figures. But hope can only carry the economy so far. The Fed has slashed its growth outlook countless times in recent years. Policymakers should consider injecting a little more realism into the mix. It would make them sound less out of touch with an economic recovery that for millions of Americans never really felt like one.
The Fed's efforts to communicate more openly with the public should be lauded, and it is only natural that there would be some growing pains in the transition from the Greenspanian days of oracle-like policymaking. But to be effective, Yellen must learn from her mistakes and recognize that even a healthy range of views must ultimately be herded into a coherent policy message.
This op-ed first appeared in Foreign Policy.