Fed’s New Wordplay to Yield Negligible Results: Caroline BaumCaroline Baum
Jan. 6 (Bloomberg) -- A forecast is a forecast. In many cases, it’s not worth the paper it’s printed on.
Some forecasts are more important than others, which is not to say they’re more accurate, just that they matter more. The Federal Reserve’s forecasts belong in this category.
Unlike the average Wall Street prognosticator, the Fed has the unique ability to make its forecast become reality through its manipulation of the federal funds rate (the overnight rate at which banks lend to one another) and control of the monetary base. That’s why the central bank’s forecasts, and what’s required to achieve them, matter.
Starting with the Jan. 24-25 meeting, we will learn for the first time what funds rate is associated with the Fed’s projections for inflation, unemployment and real gross-domestic-product growth in the current year, the next few calendar years and “over the longer run,” according to minutes of the Dec. 13 meeting released this week.
“Over the longer run” can only mean the rate that will keep the economy growing at its non-inflationary potential in perpetuity, otherwise known as the neutral funds rate. It will be an interesting academic exercise to see what neutral rate the Fed expects to yield real GDP growth of 2.4 percent to 2.7 percent; an unemployment rate of 5.2 percent to 6 percent; and inflation of 1.7 percent to 2 percent -- the central bank’s current long-term targets. How this will affect investment and spending decisions in the short run remains to be seen.
The argument in favor of greater transparency on the expected interest-rate path is that it provides greater clarity and certainty for business investment.
It could have the opposite effect. If the Fed projects slow growth, elevated unemployment, benign inflation and a funds rate of zero to 0.25 percent through 2014, businesses might be lulled into inaction. Why invest now? What’s the rush? My widgets aren’t flying off the shelf, and everything I read says consumers don’t have the wherewithal to spend.
Transparency is better than the alternative. Still, one can envision potential landmines down the road.
For starters, forecasting is an art, not a science. What happens when the Fed is forced to reverse its accommodative policy quickly because inflation isn’t behaving as it’s supposed to (even with food, energy and half of the consumer-price index excluded), inflation expectations lose their mooring, the U.S. economy gathers steam, or signs of froth appear in some asset market, the product of years of near-zero interest rates? Goodbye, certainty; hello, volatility.
Second, even in the normal course of the business cycle, projecting a higher funds rate may have untoward consequences.
“It’s a tricky situation going forward, when the time comes to start normalizing policy and the Fed reveals projections of a rising funds rate,” says Dana Saporta, a U.S. economist at Credit Suisse in New York. “We could get an outsized, undesirable market response: one of the risks of enhanced transparency.”
Would other short-term rates adjust instantaneously? What about long-term rates?
“The markets are looking at the same data as the Fed,” says Scott Sumner, a professor of economics at Bentley University in Waltham, Massachusetts.
In other words, the Fed will be behind the curve.
Finally, the Fed is opening itself up to increased political pressure. Some members of Congress may not see the need for higher interest rates, telegraphed by the Fed, at a time when unemployment is unacceptably high.
That said, it’s “a tiny baby step forward and better than what the Fed did in August,” which was to make an unconditional pledge to hold the funds rate near zero at least until mid-2013, Sumner says. Under the new procedure, which is “not a very precise or effective tool,” the promise about the funds rate is at least “contingent on an outcome for the economy.”
The biggest problem with the Fed’s elevation of communication to the level of policy tool is that it’s a poor substitute for the real thing. Just because short-term rates are close to zero doesn’t mean the Fed is out of bullets.
As I wrote in a column two months ago, the Fed has a powerful tool in the printing press. If policy makers determine that more stimulus is warranted, and I’m not saying it is, they should crank up the presses. Everything else is window dressing -- and some of it more effective than mere talk.
Want banks to lend? Stop paying them 0.25 percent interest on the $1.5 trillion they’re holding on deposit at the Fed in the form of excess reserves. Better yet, charge them a fee for holding those deposits.
David Beckworth, an economist at Texas State University in San Marco, compared the new strategy to a ship’s captain focusing on the rudder instead of the destination. (“Full employment” and “price stability” are both fuzzy.) Both he and Sumner advocate targeting nominal GDP. The decline in NGDP in 2008 and 2009, the biggest since the Great Depression, was a sign that monetary policy was too tight.
Monetary policy can only affect nominal aggregates, Sumner explained in a recent online interview with EconTalk’s Russ Roberts. “Real outcomes” depend on things such as structural factors, government policy and productivity, he said.
When the economy experiences a deep contraction, the presumption is that for any given increase in nominal income, the split between growth and inflation will favor the former.
For the moment, the Fed seems content to tinker around the edges.
“Why did the Fed put all this effort into this maybe-it-adds-something policy” when it could do something that really makes a difference? Beckworth asks.
Answer: Transparency is good. Talk is cheap. It won’t do much harm. The unintended consequences can be dealt with later.
(Caroline Baum, the author of “Just What I Said,” is a Bloomberg View columnist. The opinions expressed are her own.)
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