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February 15, 2011 7:26 pm
The US Federal Reserve is set to nudge its economic forecasts higher when it releases an update on Wednesday – although recent speeches suggest its officials are less impressed than the markets by stronger data.
The crucial number for judging the Fed’s next move ought to be its forecast for future price rises. If the Fed’s rate-setting open market committee thinks inflation in 2012 or 2013 will be above its goal of “2 per cent or a bit below”, then logically it should raise interest rates.
But a quirk in the way the FOMC makes its growth and inflation forecasts means that they are not a clear signal of its plans for monetary policy. To improve communication, some FOMC members think the Fed should consider publishing a forecast of future interest rates as well.
“I think it would be interesting to reveal what is the central tendency or the range of the Fed Funds rate that the committee expects at the end of the year that is consistent with their forecast,” said Charles Plosser, president of the Philadelphia Fed.
“I’d certainly like to explore going in that direction,” said St Louis Fed president James Bullard.
When FOMC members forecast growth and inflation they must assume “appropriate monetary policy”. That may seem innocuous, but it means that each member’s forecast is based on their ideal path for interest rates, and not what they actually expect the Fed to do.
For example, a hawk such as Thomas Hoenig of the Kansas City Fed – who has argued that interest rates should be raised to 1 per cent – should assume those higher rates when forecasting. But the result may be that his predictions do not show the inflation he is concerned about.
“It could easily be the case that two members had a very similar-looking forecast but the path of policy to get there may be very different,” said Mr Plosser.
The Fed refused a Freedom of Information Act request for its detailed guidelines on making economic projections. It said that releasing them “would hinder, rather than encourage, honest and frank communication among committee members”.
Opinions differ on how important the issue is in practice and all Fed officials argue that their forecasts convey useful information – it is just not the same information as in a private sector forecast of the economy.
“It’s not a pure forecast but the reality is that it’s not very far away,” said Frederic Mishkin, a Columbia University professor who pushed for the Fed to publish more detailed forecasts as a governor from 2006 to 2008.
“The differences in forecasts based on what individual FOMC participants believe would be appropriate monetary policy and what they expect the committee to do would not be that great,” Mr Mishkin said.
However, when there is a wide range of views on the FOMC the effect on the forecasts becomes larger. Monetary policy takes time to work so the effect is also greater on the forecasts two and three years out.
The result is that the longer-range forecasts are as much a guide to what the Fed is trying to achieve as to what it actually expects to happen. “It tells you what each individual member thinks is possible: it’s a metric on how powerful they think policy is,” said Mr Bullard.
That is valuable information but it leaves a gap: the forecasts do not give a clear signal of how the FOMC expects to change policy in the future. Giving an explicit forecast of future interest rates might help the Fed to communicate with the markets.
Mr Mishkin said publishing rate forecasts would be valuable – although less important than the FOMC agreeing on a single clear inflation objective – but he noted a difficulty.
“The problem with interest rate projections is political: the Fed could be accused of flip-flopping,” he said. Often, the Fed would not move interest rates as it had forecast when the data changed.
The Fed declined to say whether its working group on communications, led by vice-chair Janet Yellen, was looking at forecasting. Ben Bernanke, chairman, has often spoken in favour of transparency but the forecasts may not be an immediate priority.
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