While the Federal Reserve believes it will take a major step next week toward making its policies more transparent, financial markets are bracing for considerable confusion.
Fundamentally, the criticism revolves around some key aspects of the Fed’s new communications strategy to publish for the first time the forecasts of its members for the benchmark federal funds rate.
While many Fed watchers say the move should be helpful to markets over the long term, even the most experienced observers say they don't understand exactly how the new policy will work.
Some of the concerns are logistical and can be resolved with a simple briefing by the Fed; but others cut to the heart of the policy and may not be resolved either easily or ever.
A big part of the confusion is over timing. The Fed plans to release its usual statement about the policy meeting at 12:30 pm on Wednesday. It will then release its interest-rate forecasts and quarterly estimates for economic growth, unemploymentand inflationat 2 pm. After that, Fed Chairman Ben Bernanke will hold a 2:15 pm press conference, where reporters can ask questions about the new policy.
For now, here's what Fed watchers are worried about:
1) If the Fed is publishing its interest rate forecast later in the afternoon, how will it word the policy statement that comes out at 12:30? The markets closely follow these policy statements, which recently have included the forecast that the Fed expects interest rates to remain low until mid-2013. Some are predicting that the forecast will now disappear.
2) If policymakers do leave the timing out of the statement, will markets view that as a hawkish development in monetary policy, or will they know to wait for the coming forecasts later in the day?
3) Even if markets know the rate forecasts will come later, Wall Street analysts point out that there's a one-hour-and-thirty-minute gap between the policy statement and the rate forecast. That leaves markets wondering about the future path of interest rates between 12:30 p.m and 2 p.m. And markets hate uncertainty.
4) To what extent will the Fed ensure that the median forecasts for interest-rate increases actually dovetail with what the committee believes is the best policy? While perhaps far-fetched, it’s possible that the two could differ. For example, what if the median forecast sees interest rates rising in mid-2014, but the committee thinks the best policy is to keep forecasting that interest rates will remain low through mid-2015? There’s no guarantee that the two will match, unless committee members change their individual forecasts to match the committee’s policy statement.
This last question is perhaps the most vexing and cuts to the issue of what exactly these interest-rate forecasts are supposed to be. The minutes of the December meeting, in which the decision was initially announced, only say the Fed will provide “information about participants’ projections of the appropriate level of the target federal funds rate.”
But Lou Crandall of Wrightson ICAP wonders if those projections represent preferences or projections of likely outcomes. That is, is the interest-rate path the one a committee member would like to see, or the one that he or she believes is most likely?
Crandall notes that some committee members in the past have recommended a negative interest-rate path—that is, charging banks to keep excess reserves on deposit at the Fed. Would those members at the time have projected a negative interest rate, even though there were strong objections to that path from other committee members?
And, if these are preferences, then should a committee member tailor the forecast to match the consensus on the committee for the optimal policy path?
Late Friday, the Fed released a statement saying the forecasts would represent individual members' outlook for rates that is consistent with the Fed's dual mandate of low inflation and full employment.
Criticism of the policy also comes from within the Fed itself. The minutes note: “Some participants expressed concern that publishing information about participants’ individual policy projections could confuse the public.”
The specific concern is that the public will mistake the projections for a promise to keep rates low. The minutes say that “most participants” believe the concern can be managed through public comments by committee members.
St. Louis Fed President Jim Bullard did not give a resounding endorsement of the new policy at a press conference in Chicago earlier this month. He said he would prefer that the Fed publish the staff’s interest-rate projections, rather than individual members.
Drew Matus, economist at UBS, adds that markets may discount whatever long-term projections the Fed makes about interest rates because Fed Chairman Ben Bernanke’s second term ends in January 2014, when he could leave office.
So Fed policy could be in for an overhaul within the time frame of the current interest rate forecasts.
Finally, several Fed observers have said that the interest-rate projections would actually be helpful for them if the Fed linked the individual member rate forecasts with their outlooks on unemployment, inflation and growth.
This would tell Wall Street about the way individual members see the relationship between the Fed funds rate and the broader economy. That is something that could be considered by the committee.