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It has been a dramatic few months for the US Federal Reserve, with its August forecast that short-term interest rates will remain exceptionally low until mid-2013, and September’s decision to launch the $400bn “Operation Twist”.
One reason the Fed’s moves were so dramatic is that, working solely from today’s economic data, they were hard for analysts to predict. That is a problem for the Fed because there is a wealth of evidence that monetary policy works best when markets understand how the central bank will respond to changes in the economy.
The Fed’s framework for explaining policy is out of date, years behind the best practice of international central banks, and in danger of falling over completely under the strain of new policy innovations. A Fed working group is looking at these issues but some changes may be essential if tools such as the twist are to work well.
Most Fed officials guide their thinking using some kind of rule that links interest rates to how far inflation and unemployment are from target. But it is hard for outsiders to follow that thinking because the Fed has no agreed objective for inflation, no clear forecast of what inflation will be, and their recent actions do not reconcile to any obvious rule.
Current policy is poorly explained. For example, Minneapolis Fed president Narayana Kocherlakota, who dissented in August and September, has pointed out that inflation and unemployment have got better since last autumn.
In August 2010, the unemployment rate was 9.6 per cent and core inflation, excluding food and energy costs, was measured at 1.4 per cent. By this August, unemployment had fallen to 9.1 per cent and core inflation had risen to 1.6 per cent – so why ease now?
The recent easing also fits unhappily with the logic that the Fed used to explain QE2 last autumn. Mr Bernanke noted then that “inflation has declined noticeably since the business cycle peak and further disinflation could hinder the recovery”. But inflation has steadily risen for most of this year.
In addition, the Fed’s current policy is confusing in itself. At its August meeting, the Fed said it expects to keep rates “exceptionally low” until mid-2013, or 22 months. In September, it said the same thing – so it expects to keep rates on hold for 21 months – and if there is no change in November that will fall to 19 months.
Logically, if the expected period of low rates is getting shorter, then the Fed’s forecast for the economy should be getting better. But that is clearly not the case, as the September decision to launch Operation Twist – selling short-term bond holdings to buy longer-term Treasuries and bring down long-term rates – shows .
There is an explanation for all of this: the Fed acted because it is concerned about risks to the outlook for growth and inflation, caused by everything from turmoil in the eurozone to the ructions from Washington’s debt ceiling debate. But its current framework cannot easily explain this.
Three changes could make a difference. First, the Fed could finally agree on a clear inflation objective, with 2 per cent the obvious candidate. The overwhelming majority of the FOMC favours such an objective and it would be easier to explain policy if it were clear what policy was trying to do.
Second, the FOMC could change the way it forecasts inflation. At the moment, FOMC inflation forecasts assume “optimal monetary policy” but, by definition, if policy is optimal, then inflation should go back to target. That means the Fed’s quarterly forecasts say little about whether it thinks current policy is too tight or too easy.
Instead, the Fed could either forecast inflation based on market expectations of interest rates – like the Bank of England – or publish its forecast of monetary policy – like the Swedish Riksbank – or even better, do both. In that case, movements in the Fed’s inflation forecasts would better explain its policy decisions and help others to predict them.
Third, the Fed could change its forecast that short-term rates will stay low until mid-2013 to a statement they will stay low until something changes in the economy. Charles Evans, president of the Chicago Fed, suggests that could be until unemployment falls below 7.5 per cent as long as inflation remains below 3 per cent.
That may be too hard for the FOMC to agree on – but it is time to try.
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