Economists mull how to improve Fed communications

The Federal Reserve has become "too focused on time-based forward guidance", according to a group of private sector economists, who have considered how the Fed might improve its communications.

While time-based guidance might be useful in "unusual circumstances", the economists say, the Fed should normally focus on "relaying a data-based reaction function".

"If done effectively, a successful central bank communication strategy guides the market to do the heavy lifting for monetary policy by incorporating new information immediately into interest rates," they say.

The paper, authored by David Greenlaw, Peter Hooper, Michael Feroli, Frederic Mishkin (a member of the Fed's board of governors, 2006–2008) and Amir Sufi, was presented at the US Monetary Policy Forum on February 26.

Discussing the paper, Fed governor Jerome Powell said he was "not convinced" the distinction between time-based and data-based guidance had "played a central role in determining the successes and challenges" of Fed communication.

Powell did, however, find "significant grounds for agreement and further analysis" in the section of the paper laying out lessons learned and suggested improvements for the future.

Walking the rate path

One alternative the economists discuss is the use of data-based guidance with a projected path for the federal funds rate. This would mean spelling out what rate "would be expected to prevail" in different scenarios.

This "creates desirable expectation dynamics", but only if the guidance is clearly understood by markets and credible, they argue. "Another way of saying this is that data-based forward guidance is darn hard to do."

Another problem, they add, is that it "might not be more effective" than eschewing guidance altogether, as there is evidence to suggest longer-term interest rate reactions are unaffected. "Given these problems, one suggestion is that it might be better not to do it at all," the economists say.

A "weaker" form of guidance involves specifying a "balance of risks" around "specific economic outcomes". This would, they say, serve as an "implicit policy bias". This could also be strengthened through the use of "more explicit policy bias".

The Federal Open Market Committee (FOMC) experimented with this in 1999. In May that year, for instance, the committee said it was "concerned about the potential for a buildup of inflationary imbalances" and had "therefore adopted a directive that is tilted toward the possibility of a firming in the stance of monetary policy".

The economists cite the second half of 2007, when the FOMC identified "both upside risks to inflation and downside risks to growth".

"While it did give some indication of how these risks were balanced, a clearer signal to the markets would have been to say more explicitly how it saw the current policy bias, or which direction it expected to see policy move if a change were to occur at the next meeting," they argue.

However, if the Fed was to pursue data-based guidance with a future policy path, the economists believe there are ways of making it more effective, such as helping the public and markets understand the "tremendous uncertainty" about policy outcomes.

They cite the experience of Norges Bank, which publishes a fan chart showing the confidence intervals around its projected interest rate path. The economists describe this as an "excellent approach", but warn the Fed's governance structure "makes providing such a fan chart very difficult".

Nonetheless, the idea is under consideration in Washington, DC. A Fed subcommittee put forward a proposal for adopting several fan charts in the FOMC's summary of economic projections (SEP) in January. Staff noted they could "help convey" uncertainty.

Even if this proves unattainable, the economists argued Fed officials could communicate "far more" about uncertainty. "Indeed, one possibility is that individual FOMC participants could provide information about how uncertain they are about their views of where policy rates should be in the future," they say.

Beyond the dot plots

Part of the battle in achieving good guidance rests with the audience, the economists say. The financial press and market participants should "fixate less on dates", they argue, noting the conditionality in statements made by Fed officials is often ignored.

An additional recommendation is to make the SEP, which contains the so-called ‘dot plots', more "informative" about the individual reaction functions of the Fed presidents and governors. This could mean publishing the full, but anonymised, economic forecast of each individual. This data is already made available, but only after a five-year delay.

"Releasing this type of detailed information to the public at the same time as the SEP might provide additional clarity in identifying the reaction function of each participant of the FOMC," the economists say.

This could, in turn, help people "make better inferences" about the FOMC's reaction function, as "certain participants have more influence on policy decisions than others", the economists say. At the moment, Powell says, there is "no easy path to the identification of a Committee reaction function".