I'll let Morgan Stanley's Dick Berner initiated the non-initiated into the deeper mysteries of FOMC decision interpretation. As he says the Fed has improved enormously over the years: would that the monthly 'dialogue for the deaf' that seems to pass for policy explanation over in Frankfurt were to do the same.
Two decades ago, Fed watchers were like members of the Army Signal Corps, furiously trying to break the code of the Open Market Desk. Today, the Fed lets us in on the conversation, as the Fed's numerous advisory panels attest. Those small groups may be more privileged than others are, but the Fed has its own version of Reg FD. Officials regularly and freely communicate their views about the economy and policy, so all market participants can weigh the risks surrounding policy choices on an ongoing basis. Announcing policy changes, the rationale for them, and how members voted immediately following each meeting has helped all market participants understand policy intent. Now that the Fed has clarified its intent and game plan, policy has a better chance of success.
The new Fed statement vastly improves on the old model in three ways. First, it separately identifies two medium-term “balances of risks,” one for growth and one for inflation. The old statement implied that there was a longer-term trade-off between them, but neither the Fed nor most economists think that such a long-term trade-off exists. So most market participants interpreted the statement as a gauge of the FOMC's short-term policy bias. In a world dominated by demand shocks, this statement was adequate, because the trade-off seemed to work. But it was inadequate for a world in which supply shocks -- like a surge in productivity or a post-bubble reduction in inflation expectations -- are at work. Separating the medium-term risks for growth and inflation clearly identifies the benchmarks for policy action, but does not commit to any near-term change in policy.
The second improvement involves a step toward reinstating a policy bias. The Fed had been trying to get away from stating that bias because it legitimately did not want to commit to a future policy action. Hence the “balance of risks” was born. But the FOMC understandably was ambivalent about whether the statement should appraise risks for the economy or be an announcement about policy bias. That's because it really wanted to convey -- and should convey -- some of both. However, trying to convey two messages with one statement in November of last year exposed the weakness in the formula. The FOMC shifted to a neutral risk assessment when economic weakness and lower inflation were the dominant risks. Officials were concerned that financial markets would overreact and wanted to tell market participants that the change was a one-off insurance move.
Officials haven't quite fixed this flaw. The latest statement says that, "taken together, the balance of risks to achieving [the FOMC's] goals is weighted toward weakness over the foreseeable future." Every headline and most analysts saw this as a bias toward ease, with a weak economy the trigger for action. That blurred slightly the Fed's masterful separation of growth and inflation risks. In my view, the Fed should eliminate this blurring; officials should be willing to say whether policy is north or south of equilibrium. The recent statement could have said, "Taken together, the balance of risks prompted the Committee to adopt a directive that was biased toward a possible easing of policy going forward." And officials could have made it clear that, as they stated on October 5, 1999, the "directive might not be a commitment to near-term action." To clarify policy intent, I think the Fed should speed up the release of the minutes of the FOMC meeting, to the end of the second week after the meeting. If it does so, it can leave most of the nuances for that document.
The third and most important improvement in the statement is that in an era of price stability, it marks an important step toward targeting inflation. Fed Governor Bernanke recently spelled out the benefits and costs of such a move (see his "A Perspective on Inflation Targeting, March 25, 2003). I agree with Bernanke that such a step, with or without a numeric inflation target, clarifies the Fed's policy framework, so that officials have clear guidelines for action. I also agree that it makes policy goals easier to get across to the public at large, which increases the odds the Fed will achieve them.
Source: Morgan Stanley Global Economic Forum
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