Best Guess as Policy Tool

Palm Beach, FL 1/18/12 (StreetBeat) --Four times a year the Fed issues their Summary of Economic Projections (SEP). The SEP includes their outlook over various horizons for key economic indicators such as unemployment, growth and inflation. In theory this report should be useful at the margin in judging how the Fed sees the economy playing out and what that might mean for the future path of the federal funds rate. But starting at the January FOMC meeting the market’s analysis of the implications of the key economic indicators for the funds rate will have a short cut. That’s because beginning next week “the SEP will include information about participant’s projections of the appropriate level of the target federal funds rate in the fourth quarter of the current year and the next few calendar years, and over the longer run; the SEP will also report participant’s current projections of the likely timing of the first increase in the target rate given their projections of future economic conditions.” So says the minutes from the December FOMC meeting at which this change was discussed and agreed upon.

Of course the Fed has offered forward guidance on the path of fed funds before and is currently doing so now. Since last August they have said in their post policy meeting statements that the Committee “currently anticipates that economic conditions—including low rates of resource utilization and a subdued outlook for inflation over the medium run—are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” While the new wrinkle on forward guidance for the funds rate will offer more information, in particular the outlook for the timing of the next move in the target rate, the basic strategy remains the same; it is viewed by the Fed as a policy tool that is intended to influence interest rates further out the curve in a way that best benefits the Fed’s stance on monetary policy. So, for instance, when the Fed took the funds target rate down to a range of 0 to 0.25% in December 2008 they added to their statement that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.” They repeated the phrase “for some time” in January 2009 and then changed the wording to “for an extended period” at the following meeting in March. Fed Vice Chair Yellen noted in a speech last February that “the provision of guidance concerning the future path of the federal funds rate” in those statements likely contributed to more accommodative financial market conditions as the market took that outlook to heart. And that is what was supposed to happen. Because, as Yellen explained in her speech, once Fed policy became constrained by the lower zero bound on the funds rate the Fed still wanted to ease policy further, and this forward guidance on the future path of the funds rate, in addition to asset purchases, was a way to achieve that policy goal.

Clearly, the majority of the Fed members still want to have more accommodation than the zero bound funds rate allows them to have; that is why they continue to say that the funds rate will remain so low for so long. But it is important to note that the new funds rate forecast in the SEP, just as the language used up this point, is not etched in stone. And while the Fed could still use this strategy as a way to do an end run around the zero bound funds rate, at some point it will act as a signal that the Fed is getting ready to hike rates. “A crucial feature of the FOMC’s policy communications is that the Committee’s forward guidance has been framed not as an unconditional commitment to a specific federal funds rate path, but rather as an expectation that is explicitly contingent on economic conditions,” said Yellen last February.

Although Fed policy is always conducted amid some degree of uncertainty on the future, the fed funds forecast to be included in the SEP puts the Fed’s best guess on display as policy tool as never before. While the intention is greater clarity, the potential may be equally weighted for greater muddle, or a whiplash reaction by the market to a mistaken assumption, a Fed best guess gone wrong.

Last week the transcripts from the 2006 FOMC meetings were released. In a review of these papers the New York Times noted that even in the face of deteriorating data on the real estate market and disturbing anecdotes about the extreme efforts home builders were increasingly having to employ to drum up new sales, the Fed “gave little credence to the possibility that the faltering housing market would weigh on the broader economy…Instead they continued to tell one another throughout 2006 that the greatest danger was inflation—the possibility that the economy would grow too fast.” At the first FOMC session of 2007 the post meeting statement said that “some tentative signs of stabilization have appeared in the housing market.” They reached this conclusion even though one measure of housing prices, the Case/Shiller Index, had barely budged from its all-time high after it had more than doubled since the beginning of the decade. The Fed’s analysis of the housing market was wrong. Their lack of appreciation of the havoc that the mortgage market would wreak on the financial system was lacking. Their best guess on the future path of the funds rate, if it were to have been published back then, would likely have been misleading.

When the Fed met in June 2008 the Bear Stearns affair had been laid to rest three months hence. The economic assessment that was presented in the post meeting statement in June was more upbeat than it had been at the previous meeting and much better than was the case when they convened in March amidst the turmoil of the Bear Stearns resolution. The better sentiment expressed by the Fed in June convinced the market to price in not one, or two, but three, quarter-point rate hikes by year end. Well, as it turns out the funds rate did not rise from 2.00%, the prevailing level at the time of the June FOMC meeting, but instead it was cut down to its current range that has zero as its lower boundary. It is not fair to assume that had the Fed been offering their best guess on the future path of the funds rate in the SEP at that time that they would have endorsed that expectation, but I don’t recall a resistance campaign by Fed speakers early that summer to counter the market’s view.

I also wonder how the SEP funds rate outlook would have handicapped the Fed’s own chatter in 2010 about their “exit strategy” planning. I don’t think it is unreasonable to think that it would have produced a red herring expectation that would have eventually needed to be thrown back to the sea.

More information is good, but this is not to say that more information is always reliable.

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