Fed Refuses to Share Internal View Traders See Underlying Significant Risk
At BNP Paribas (BNP) SA’s New York trading desk, Julia Coronado, the bank’s chief North America economist, watched as three words helped undermine the Federal Reserve’s latest attempt to aid the U.S. economy: “significant downside risks.”
The phrase, tucked into a seven-paragraph policy statement about the Fed’s plans to move $400 billion into long-term debt from short-term bonds, warned about the economic outlook while offering no clue on the risks’ severity. The Sept. 21 statement said Fed officials expected “some pickup” in the pace of recovery, though unemployment would “only gradually” decline.
Before they acted last month, members of the Federal Open Market Committee saw far more specific predictions. They had “the Teal Book,” an economic forecast that Fed Chairman Ben Bernanke’s staff of 50 or so Ph.D. economists produces every six weeks -- with numeric forecasts for unemployment, growth and inflation down to the decimal point. The document, so influential it’s been called the “13th member” of the 12- person FOMC, is withheld from the public for five years -- unlike the forecasts of other central banks.
Without such specifics, Fed watchers like Coronado, who keeps a rubber Bernanke doll taped atop her computer screen, are left to parse the qualitative language of Fed statements. Last month, investors decided the words meant it was time to buy bonds and sell stocks; the Standard & Poor’s 500 Index closed 3 percent lower that day.
‘Scary and Confusing’
“The statement was both scary and confusing to many people,” said Coronado, who broadcasts her interpretations of Fed statements to hundreds of Paribas traders from a microphone on her desk in New York each time the FOMC reports. “If there are significant downside risks, what are buying and selling bonds going to do? That isn’t clear to anybody but the most sophisticated bond investors.”
Now, after Congress and federal courts mandated unprecedented disclosures of the Fed’s lending during the financial crisis of 2008-09, a growing number of economists and investors say the central bank should embrace additional transparency and begin releasing the Teal Book forecast.
“Just as the governors should have some accountability, the staff should have some accountability for its work,” said Alan Blinder, a former Fed vice chairman and now a Princeton University professor. “I have always argued that the staff forecast should be public.”
Federal Reserve spokesman David Skidmore said the committee hasn’t considered the question of whether to publish the staff forecast. “Policy makers’ own economic forecasts, rather than those of staff, form the basis for monetary policy decisions,” he said in an e-mail. Their views on the outlook are reflected in the minutes of every FOMC meeting, he said.
Make the Case
With its main policy rate held at zero since December 2008, the Fed has turned to unconventional policies, including last month’s shift into longer-term securities. Publishing its forecasters’ best economic outlooks could help make the case for its actions, said Mark Spindel, chief investment officer at Potomac River Capital LLC, a Washington hedge fund with $300 million under management.
“What does the Fed know that we don’t know?” he said. “Two things. They know where the economy is better than anybody else. Nobody has the same firepower and access to data. Second, they know themselves, and how they’re going to react. Their job would be so much easier if they would help the market understand what they are trying to do.”
Other Central Banks
Central banks around the world publish elaborate reports about their economic outlook, often tied to specific, numeric inflation goals. The European Central Bank publishes a staff outlook for economic growth and inflation, as does Brazil’s central bank. While Fed officials have had internal discussions about releasing the Teal Book, the idea has never been presented to the FOMC for final consideration.
One reason: concern that the staff might “pull its punches” to avoid the market reaction a negative forecast would produce, said former Fed Vice Chairman Donald Kohn, who led a panel Bernanke created to consider transparency issues in 2006.
“We saw in the last announcement how powerful an effect a gloomy Fed outlook can have on the markets,” said Kohn, now a senior fellow at the Brookings Institution in Washington. “I don’t want the staff to even think about that.”
The Teal Book takes its name from the combination of previous documents known as the Blue Book and Green Book, for the color of their covers, into one volume. The Fed does make public its regional economic survey, known as the Beige Book, which comes out every six weeks.
The staff forecasts often include simulations of how the economy might respond to certain unlikely events, such as multiple bank failures; those could startle financial markets if investors assigned too high a probability to them, Kohn said.
Also, releasing the Teal Book might complicate the message that Fed governors and reserve bank presidents send markets when they publish their own forecasts four times a year, Kohn said.
“It’s the committee’s outlook that should justify the policy,” and that forecast should be updated when the panel takes action, he said.
Yet the Fed officials’ published outlook is of little value compared with the staff forecast, according to research published in 2008 by Christina and David Romer, professors at the University of California at Berkeley. They analyzed FOMC and staff forecasts from 1979 to 2001.
Staff Projections Better
“When it comes to forecasting, U.S. monetary policy makers do not have useful information relative to their staff,” the Romers concluded. “Someone wishing to predict inflation and unemployment who had access to both the FOMC and staff forecasts would be well served by discarding the FOMC forecast and just using the staff predictions.”
The Teal Book is intended to give Fed officials a baseline story about how growth, employment, and inflation are likely to evolve. Policy makers, including Chairman Bernanke, can reject it, take a position on either side of it, or embrace it.
The forecast isn’t infallible. This year, volatile financial markets, the Japanese earthquake, and a rise in oil prices in March and April have caused staff members to cut their near-term outlook five consecutive times since March, the longest string of cuts since the recession ended in June 2009, according to Fed meeting minutes that don’t provide quantitative details of the staff outlook.
Forecasting Katrina’s Effects
At other times, the forecast provided a critical benchmark for tough policy calls. The one for September 2005 -- one of the most recent that’s publicly available -- shows staffers scrambled to assess the damage of Hurricane Katrina, which hit Louisiana on Aug. 29 that year. Despite the human tragedy, they concluded the loss of real net worth for the economy would be just $76 billion, or about 0.1 percent of national wealth. The staff estimated that unemployment would average 5 percent in the final quarter of 2005. It averaged 5.0 percent.
Members of the FOMC looked past Katrina’s short-term impact on the economy and raised the benchmark lending rate a quarter- point to 3.75 percent on Sept. 20.
The six-week timetable for each staff forecast allows it to adjust to changing conditions more frequently than the open market committee’s outlook, which comes out four times a year.
The most recent FOMC forecast dates to June, when the committee expected 2011 growth in a range of 2.5 to 3 percent. Since then, many economists have moved the target lower; Macroeconomic Advisers LLC, a St. Louis-based firm, currently has a growth estimate of 1.6 percent, following a flow of downbeat economic data. High-frequency policy changes require publishing updates more often, economists said.
‘Plain and Simple’
“They should publish their staff forecasts, plain and simple, as part of a move towards greater transparency and to align Fed communication policy with international best practices,” said Michael Gapen, senior economist at Barclays Capital Inc. and a former section chief at the Fed’s Monetary Affairs division.
The FOMC will present its latest forecast to the public at the conclusion of its policy meeting on Nov. 2. Bernanke will discuss the updated outlook in his news conference after the meeting.
While Bernanke is part of a generation of economists who hold that transparency makes central banks more effective, Congress and the courts have also mandated a new era of openness at the Fed. Bloomberg LP, the parent company of Bloomberg News, won court orders requiring the U.S. central bank to release emergency lending records from the financial crisis of 2008-09 after a legal fight that lasted more than two years.
Amid that litigation, Congress inserted provisions into last year’s Dodd-Frank financial regulatory overhaul that require the Fed to release information on its loans to financial institutions on a two-year lag.
‘Marcel Marceau’ Policy
Bernanke said transparency “increases democratic accountability” in his November 2005 nomination hearing. He has argued in favor of providing “quantitative guidance” on the Fed’s inflation goal and once criticized central banks that engage in “Marcel Marceau” monetary policy, “allowing its actions to convey all its intended meaning” like the French mime.
His push to get the Fed to say more contrasts with his predecessor Alan Greenspan, whose steps toward transparency “rivaled that of a snail,” Blinder said in a research paper. Bernanke this year began holding four news conferences a year, a first for a Fed chairman. In 2007, the FOMC announced it would publish its forecasts four times a year, instead of two.
Bernanke has established a subcommittee led by Fed Board Vice Chairman Janet Yellen to look into further transparency steps. The group is focused on publishing more precise information about the FOMC’s goals for prices and employment, and more guidance about how policy changes are linked to those goals, according to minutes of the Sept. 20-21 meeting. The minutes don’t indicate the committee is considering the publication of the staff forecast.
Still, monetary policy changes frequently, as does the economic outlook, and the Fed’s policy responses are no longer as simple as an interest rate cut; the benchmark lending rate hit zero in 2008 and hasn’t moved since. The central bank has scooped up $2.3 trillion in U.S. Treasuries, housing agency and mortgage-backed security debt in an attempt to lower yields broadly since March 2009. In August, the FOMC pledged to keep the benchmark lending rate at around zero for the next two years.
Minutes of the August meeting said the two-year rate pledge was “consistent” with a “model-based” analysis -- though neither the model nor the analysis were released.
Congress Seeks Data
A few weeks later, Republican congressional leaders, including Senate Minority Leader Mitch McConnell and House Speaker John Boehner, sent Bernanke a letter asking the Fed to “resist” further action, “particularly without a clear articulation of the goals of such a policy, direction for success” and “ample data proving a case for economic action and quantifiable benefits to the American people.”
Bernanke and the policy committee ignored the advice. In addition to shifting $400 billion into longer-dated Treasury debt, the FOMC announced Sept. 21 that it would reverse plans to let mortgage-backed securities run off gradually, maintaining its $862 billion investment in housing finance.
Minutes from the September meeting say the shift in the Fed’s portfolio was warranted by “revisions to the economic outlook.” There is no quantitative presentation of what those revisions were.
The comparatively vague language that the FOMC did release spurred a 674.83-point, 6 percent decline in the Dow Jones Industrial Average over two days, showing the costs of limiting information, said Roberto Perli, a former member of the Fed Board’s Division of Monetary Affairs, which prepares one section of the Teal Book.
“If the markets are left with uncertainty about what the Fed can do and what its outlook is, this is the reaction you can expect to get,” said Perli, now managing director at International Strategy & Investment Group in Washington.
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