In the past five years, investors and the public at large have essentially had an all-access pass to the inner workings of where monetary policy at the U.S. Federal Reserve Board and other central banks is headed. But that ticket will eventually expire.
One could be forgiven for assuming that policy makers are on an evolutionary path to ever-more openness, in light of the stream of information that now flows from central banks in the form of published forecasts of growth, inflation and policy rates. It was not always thus, to put it mildly.
Central bank communications have come a long way since the era when monetary policy was thought to be only effective if the action was kept secret – a tactic common up to the 1970s. Fed vice-chairman Janet Yellen noted in a speech last year that the first tears in the shroud of secrecy appeared at that time. The Fed was drawing criticism from many academics, such as James Tobin and Milton Friedman, who argued that central bank secrecy was not consistent with democratic principles. This found its way to the ears of politicians, who threatened to take away some of the Fed’s independence if it did not become more forthcoming.
Eventually the Fed succumbed to the pressure and agreed to publish notification of policy actions, though well after the fact. At that time, private-sector analysts could make a good living by honing the skill of reading monetary aggregate publications (the Fed’s preferred target for monetary policy) out to the trading room, while upside down under the scroll of fax-machine paper.
Those acrobatic skills became obsolete as the 1990s wore on. The Fed became aware that communication of policy moves helped transmit rate moves into the economy, essentially giving monetary policy a more immediate impact, and became even more willing to provide information. Eventually the Fed began publishing policy rate moves and an accompanying statement explaining the reasons for the decision. In the late 1990s, during the tenure of chairman Alan Greenspan, the Fed even experimented with some early forms of forward guidance by providing an indication of where the central bank’s policy-setting body, the Federal Open Market Committee (FOMC), believed the risks to inflation were skewed.
By the early 2000s, however, concern was voiced over just what was the right amount of information a central bank should share with the public. Many within the FOMC reasoned that providing too much information about what the Fed thought the future would hold was prompting investors and households to take too many risks. Essentially, the public was paying attention only to the guidance without thinking through whether the Fed was correct about the economic outlook and would therefore renege on the policy stance.
Guidance about the future direction of monetary policy faded from Federal Reserve communication, to be replaced by a discussion of the outlook for the economy – to force the public to draw their own conclusions about what it meant for the future direction of policy rates.
As the subprime crisis brewed through 2006 and 2007, the Fed and other central banks slashed interest rates, eased credit conditions by purchasing securities from primary dealers and, eventually, came to grips with the prospect of hitting essentially zero on interest rates. Faced with this limit on conventional monetary policy, the Fed turned to outright quantitative easing (asset purchases) in 2008, knowing full well that this so-called unconventional monetary policy was much less effective at stimulating the economy and keeping inflation expectations stable.
It was at that point that the Fed turned to enhanced communication strategies – to ensure the asset purchases had the desired effect of lowering long-term interest rates. In the past year, the Fed has even gone so far as indicating the time frame in which FOMC participants expect the federal funds rate would begin to rise, and have spelled out specific unemployment-rate and inflation-rate thresholds at which rate hikes would be on the table – which many investors have interpreted as firm commitments.
As Ms. Yellen and other Fed officials have noted, clear communication with the public may become even more critical in anchoring inflation expectations as the Fed starts the unprecedented task of unwinding extraordinary monetary policy by reducing asset purchases, then eventually reducing the number of Treasury notes and mortgage-backed securities on its balance sheet.
Still, at some point, the global economy will return to a more normal state, policy rates will increase, and the Federal Reserve will once again reflect on how its actions make an impact on risk-taking. Mindful that the costs of excessive risk-taking may occasionally exceed the benefits of easy policy transmission, the Fed will no doubt dial down communications. That will leave investors themselves to decide what the economic outlook will mean for the future direction of policy rates.
Sheryl King is an independent macroeconomic strategist with more than 20 years’ experience in the international financial industry and central banking.