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|Stephen D. Oliner||January 2nd 2013|
Real Clear Markets
A full assessment of the Bernanke Fed is still years away. That said, a favorable judgment can be rendered already on the changes the Fed has made in how it communicates with the public about monetary policy. With a strong push from Bernanke, the Fed has moved a long way toward greater transparency. But there is still important unfinished business on the communication agenda that relates to the Fed's tolerance for inflation. I hope this issue will be addressed in Bernanke's final year. Before we turn to the unfinished business, let's review the highlights of what has been done already:
· Over the past five years, the Federal Open Market Committee (FOMC) has greatly enhanced the forecasts it releases to the public. The latest forecast, released in the December Survey of Economic Projections (SEP), shows the outlook for economic growth, unemployment, and inflation annually out to 2015, along with a longer-run forecast of these variables after the economy has fully recovered. The SEP also presents forecasts for the federal funds rate. Although these forecasts are often wrong - they have been too optimistic about the speed of the recovery - there's no longer any need to guess what the FOMC is thinking.
· The Chairman's press conferences, initiated in April 2011, have been a truly revolutionary change for an institution that cloaked itself in secrecy. We've become used to seeing Bernanke subject himself to tough questioning from savvy reporters, so it's easy to forget that no previous Fed chairman had been willing to do this.
· Early last year, the FOMC established an explicit target for inflation, a step Bernanke had long favored. All the previous guesswork and indirect signaling about the Fed's goal for inflation has been replaced by a clear statement that its target is 2 percent.
These changes in communication are here to stay, and together they represent an important accomplishment for the Bernanke Fed.
In addition to these permanent changes, the statement issued after each FOMC meeting since December 2008 has provided guidance about when the Committee thinks the funds rate will begin to rise. Unlike the SEP, which presents the individual forecasts of the 19 Committee members, the forward guidance in the statement reflects the consensus of the voters at that meeting and is heavily influenced by the Chairman's own position; thus, it carries a lot of weight in financial markets. Until the meeting last month, the forward guidance had been stated in terms of a calendar date ("at least mid-2015", for example). But the FOMC had never been happy with the calendar-based guidance because it provided no window into the Committee's thinking about the conditions that would spur the first rate hike. At its meeting last month, the FOMC finally settled on those conditions: the funds rate will likely remain near zero at least as long as the unemployment rate is above 6½ percent, the FOMC projects inflation to be 2½ percent or less, and long-term inflation expectations remain well anchored. By couching the rate guidance in terms of economic conditions, the FOMC has clearly defined the thresholds for the first rate increase - another step forward for Fed transparency.
The most important element of the new rate guidance is the 2½ percent threshold for projected inflation. This is the first time the Fed has indicated how much inflation it views as acceptable around the 2 percent target. The fact that the threshold is so low clearly signals that the Fed has very little tolerance for inflation above its target. The Fed learned a painful lesson in the 1970s about the danger of accommodating higher inflation and is determined not to repeat those mistakes.
The numerical inflation threshold, however, is not a lasting feature of the Fed's communication policy. It relates only to the conditions that will prompt the funds rate to be raised from its current range of 0 to ¼ percent. Once the lift-off occurs, the 2½ percent inflation threshold is no longer relevant. From that point forward, we are back to a situation in which the Fed's tolerance for inflation is left unstated. Addressing this communication gap is the Bernanke Fed's unfinished business.
The best way to proceed would be for the FOMC to revisit its statement on longer-term goals and strategy. This is the statement that unveiled the Fed's explicit inflation target last January. Apart from announcing the 2 percent target, the statement is remarkably light on content. It simply says the FOMC will follow "a balanced approach" to monetary policy when inflation and unemployment deviate from the Committee's desired levels, consistent with the Fed's dual mandate. The operational details are completely absent.
We now know, however, the FOMC is uncomfortable taking actions to push down unemployment when it projects inflation to be above 2½ percent. That sentiment should be added to the statement on longer-term goals and strategy, along with symmetric language about its discomfort with projected inflation falling below 1½ percent. This language would make clear to the financial markets, businesses, households, and politicians that the Fed is serious about keeping inflation close to its target, not only today but for decades to come. Hardening the Fed's commitment to low and stable inflation in this way is a worthy objective for Bernanke's final year and would be an important element of his legacy.
Stephen Oliner is a resident scholar at the American Enterprise Institute and a senior fellow at the UCLA Ziman Center for Real Estate. He was formerly an associate director in the Division of Research and Statistics at the Board of Governors of the Federal Reserve System.