FOMC forward guidance adds to 'market confusion', say leading US economists

The Federal Reserve's communication is creating confusion about its policy intentions, according to an upcoming paper by three leading US economists.

"A disturbing disconnect has opened up between Fed officials and financial market participants," argue Charles Calomiris, Peter Ireland, and Mickey Levy in the paper, which will be published by Central Banking in the next week.

The three are members of the Shadow Open Market Committee (SOMC), an independent organisation founded in 1973 that evaluates US monetary policy.

They attribute the disconnect to the Federal Open Market Committee's (FOMC) "clumsiness" in communicating its outlook and intentions, which they add stems from the "lack of a clearly formulated strategy for normalising [interest] rates".

Far from guiding investors' expectations, the authors argue, FOMC policy statements "highlighting the virtues of being 'patient' or 'data-dependent' only add to market confusion".

Moreover, they call on FOMC members to "stop giving mixed signals" in speeches, which they argue have "clouded" market sentiment.

Taylor rule sets Fed funds rate at 1.25%

The paper, A more effective strategy for the Fed, calls on the FOMC to begin raising the Federal funds rate gradually in June 2015 to avoid a "costly overshooting of its long-run inflation target" later on.

"Higher interest rates are nothing to be feared, but to the contrary are required by solid economic growth and a remarkably robust labour market that has been unfolding," the authors argue.

They take the FOMC to task for relying too heavily on labour market indicators, while failing to determine when unemployment is structural or cyclical in nature.

"The main policy lesson of the recent history of employment and wage growth is that economic models and monetary policy makers are not very good at predicting the level of the natural rate of unemployment, particularly after a long-lived, deep recession," they note.

This, they add, reinforces the need for the Fed to adhere to a "disciplined inflation targeting rule" – they argue in favour of a Taylor rule – "rather than focus too much on labour market indicators whose meaning remains highly uncertain".

"Although first proposed in 1993 – more than twenty years ago! – the Taylor rule appears, if anything, to be even better suited to guiding Fed policy today," according to Calomiris, Ireland, and Levy. They add that the Taylor rule now calls for a Federal funds rate target of around 1.25%.

"The Fed must remain forward-looking, confident that its past actions have been sufficient to drive inflation back to target and calibrating its next set of moves to avoid a potentially dangerous overshooting of inflation two to three years ahead," they write.