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There’s nothing wrong with Fed’s forward guidance

Alan Greenspan had an important message to send about bubbling stock markets. So how did he do it? He buried it in a dozen dense sentences at the end of a speech at a boozy, black-tie dinner.

"It was pretty hard to process, especially if you'd had a drink or two during the cocktail hour and were hungry for dinner to be served," Mr. Greenspan recalled in The Age of Turbulence, the former Federal Reserve chairman's memoir from 2007.

This was Mr. Greenspan talking about his "irrational exuberance" speech to the American Enterprise Institute's annual dinner in December 1996.

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Mr. Greenspan had grown quite concerned about the enthusiasm for internet stocks, and he had begun a conversation at the Fed's policy committee about whether higher interest rates were necessary to deflate the bubble. Yet instead of being forthright, he peeked out from behind a wall of jargon and winked. In the Greenspan era, they called this transparency.

Janet Yellen's congressional testimony Tuesday will be easier to decipher. While she served under Mr. Greenspan's cult-of-personality approach to policy making, Ms. Yellen is a disciple of Ben Bernanke, her immediate predecessor, who used the financial crisis to convince the Fed to adopt an inflation target, press conferences and clear speaking. Mr. Greenspan never gave an interview during the 19 years he served as chairman. Ms. Yellen already has given her first, to Time magazine in January.

Communication strategy promises to figure prominently at Ms. Yellen's appearance at the House Financial Services Committee.

There is widespread grumbling about the Fed's current "forward guidance," the central bank's description of where interest rates are likely headed.

In December, the Fed said it would leave its benchmark lending rate at zero until the jobless rate falls to something "well past" 6.5 per cent. The Labor Department reported last week that the unemployment rate in January was 6.6 per cent, prompting a chorus of professional Fed watchers to trumpet the central bank's apparent failure to communicate. "At some point…the Fed is going to have to throw this threshold away completely, adding one more morsel to the alphabet soup of measures that have come and gone since the Great Recession," Michael Gregory, an economist at BMO Nesbitt Burns, wrote in a note Monday. Financial Times columnist Edward Luce called the Fed's forward guidance "kabuki," declaring that the "Fed's armoury is bare."

Ms. Yellen, who worked closely with Mr. Bernanke in developing the Fed's communications strategy, might respond to her critics by asking what part of "well past" 6.5 per cent do they not understand? Everyone who pays the Fed more than scant notice knows that some members of its policy committee favour setting a new threshold of 5.5 per cent. That is a minority view, but it still helps define the future. The Fed is clearly a long way from adjusting its current course.

There is a widespread view that explicit forward guidance is a waste of time because investors base their decisions on their own expectations, not what the Fed is telling them. The violent reaction last year to the Fed's surprise decision to delay trimming its monthly bond-purchase program suggests otherwise. The data clearly showed the economy was slowing down, yet many investors decided to price an end to quantitative easing based on what they though they were hearing from the Fed. The Bank of Canada's assessment of its experiment with explicit forward guidance is that transparency caused a material drop in short-term interest rates.

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The criticism of forward guidance has an echo of disappointment over something the policy makers never promised. The Fed, the Bank of England and others that that are trying to inspire confidence by being as clear as possible about their intentions have never pretended they were capable of perfect foresight – they always said they would adjust policy to economic circumstances.

Ms. Yellen surely will update Congress about the Fed's thinking on the economy, at least to the extent she can without having met with the policy committee. Her interpretation of slower-than-expected payrolls growth in December and January will be important, as will anything she says about the indicators she is using to supplant the unemployment rate.

The nice thing is that she will be clear about it.

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