The presidential season has started in earnest. First to hit the hustings was the president of the Federal Reserve Bank of Boston, Eric Rosengren, who, true to his blue-state roots, pressed the case for an open-ended asset purchase program. Dallas Fed President Richard Fisher made the red-state argument for easing off the monetary gas pedal. Increased chatter from Fed officials is a marker Morgan Stanley’s Vince Reinhart has long-identified as signifying increased chance of Fed action. And we are hearing it. But why do Fed officials talk so much in advance of action?
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There are two parts to the answer related to two different design flaws of the Federal Reserve. First, an FOMC meeting is a terrible venue for policy makers to exchange views. Second, even if they could talk it through, Fed officials cannot agree as a group on what they individually want.
A Failure to Communicate
The Fed’s failure to communicate internally owes to an irony of increased openness. In 1994, under considerable Congressional pressure, the Fed became more transparent. One initiative was for historians. The FOMC decided to release lightly edited, but otherwise complete, transcripts of every meeting, five years after the fact.
What followed was a predictable social dynamic that is never factored in by economists in their theoretical reasoning that more transparency is better. Starting that year, speakers at an FOMC meeting were given a rough draft of their remarks a few weeks after each meeting. Most learned, to their surprise, that they were a lot less lucid speakers than they had imagined. Off-the-cuff responses to prior speakers looked unthoughtful in black and white. Almost immediately, some began bringing prepared remarks. This set off a readiness race that ended with virtually everyone reading from prepared texts.
Meetings got longer and less spontaneous. More problematic still, meetings became a less useful way of exchanging information and changing minds. This led to a new dynamic: When policy views are scripted, the window to influence views opens before the meeting, when scripts are being written, not during the meeting, when scripts are being read. Thus, Fed officials give more speeches and interviews before meetings to signal each other what they will read at the meeting. If a policy issue is contentious—if it is a close call—then the volume cranks up. It just so happens that the free investing world is listening to that conversation.
A Failure to Agree
But why can’t they agree? Most applied work on monetary policy reaches the conclusion that conditional policy rules work best. That is, the policy instrument should be linked to economic performance relative to the central bank’s goal. Rather than announce a program set in amount and duration, the Fed should link changes in its balance sheet to ongoing shortfalls in achieving its dual objectives. The desire for a conditional commitment is shown in both President Rosengren’s call for an “open-ended” program and Chicago Fed President Evan’s proposal to tie action to the deviation of unemployment from its natural rate as long as inflation is contained.
Conditional commitments provide the reassurance that the central bank will keep trying until the economy performs better. If the rule is crafted correctly, it can build in an exit strategy that will be activated when data show the Fed is starting to meet its goals. At that juncture, the Fed would begin to reduce the balance sheet in a symmetric fashion to the expansion triggered by earlier shortfalls. Moreover, rule-like behavior by the Fed leads to more automatic stabilizing behavior by investors. If the economic outlook deteriorates, for example, market prices will build in the expectation of additional accommodation in advance of the official announcement to act.
Why doesn’t the Fed pin policy to some rule?
We have argued previously that most of the Fed’s problems in communications stem from three obvious, but not always well understood, principles. Those roadblocks are structural to the design of the institution.
- Ambiguity. The mission at the heart of Fed policymaking is ambiguous. In the Federal Reserve Act, the Congress tells the Fed to foster maximum employment and stable prices but is silent on how to weigh deviations from the two objectives or how quickly those deviations should be eliminated.
- Diversity. Fed officials fundamentally do not agree among themselves on how to weigh relative deviations from the two goals.
- Democracy. Chairman Bernanke entered office wanting to create a more democratic policymaking committee. This attitude was shaped by his own experience as a Fed governor and academic work indicating that a group makes better decisions than an individual does.
Together, these features explain why the Fed has difficulty in being specific about its policy rule. Specifying a policy rule butts against the core problem of the dual mandate. The Fed is assigned an ambiguous task (Principle 1), and its leaders do not agree on its interpretation (Principle 2). Absent the imposition of order by the chairman (in violation of Principle 3) or a change in the legislated mandate (which is not in the cards in the near future), the FOMC will not be able to pre-commit on future contingencies. As a consequence, they prefer to lay out programs in fixed amounts with set start and end dates. A fractious committee is unwilling to make conditional decisions that might depend on the interpretation of the staff or FOMC leaders later on.
Fed officials must be disappointed by an economic outlook that falls short of both of their objectives. They individually think that policy can do better, but they cannot collectively agree on how.
Source: Morgan Stanley
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