Thursday, December 15, 2011

Counter-cyclical Fed communication strategy

When the history of central banking is written, historians will surely devote a substantial part of the book to the aftermath of the bursting of the sub-prime mortgage bubble. As financial markets veered at the edge of precipice and the Great Recession took hold, and fiscally constrained and politically paralyzed governments largely abdicated the policy making space, central banks were left with the onerous task of stabilizing financial markets and restoring economic growth.

Central banks, led by the American Federal Reserve and the Bank of England, have deployed a wide range of monetary policy tools to stabilize markets and boost aggregate demand. These unconventional monetary easing approaches like quantitative easing policies have contributed to a dramatic ballooning of the balance sheets of central banks across the developed world.

In keeping with such changes, central banks have also sought to make more effective use of their communication strategies to anchor market expectations. One of the most important instruments of central bank communication has been the publicly announced commitment to keep interest rates low for extended periods of time. The Federal Reserve in the US had very early in the crisis announced its commitment to keep interest rates low for "and extended period of time". Subsequently, it went further in providing greater clarity to this phrase by announcing in August that it planned to keep rates near the zero bound till atleast the summer of 2013. The objective is to firm expectations among various market participants and reduce uncertainties about consumption and investment decisions.

Now, the NYT reports that the Fed is planning to make publication of interest rate forecasts a permanent feature of its monetary policy communication strategy. The Times writes,

"Forecasting policy is part of a broader set of changes that the Fed is considering to improve public understanding of its methods and goals. The Fed’s chairman, Ben S. Bernanke, and other officials say that improved communications could deliver a modest boost to the economy with relatively little risk. None of their other options for additional action are nearly so appealing...

Such a forecast likely would cover the expected path of policy over the next three years, including information about the range of predictions. The Fed already publishes similar predictions about economic growth, inflation and unemployment four times a year."

While the attempt to shape longer-term expectations to revive the "animal spirits" is understandable during such recessionary times, there will be questions raised about the wisdom of such upfront commitment during upturns in the business cycle. For example, during an economic recovery when financial markets are booming and inflationary pressures are rising, such upfront commitment to keep interest rates low would, instead of leaning against the wind, be amplifying the market exuberance. It would run contrary to the conventional wisdom on central banking - "take the punch bowl away when the party gets going".

Such upfront commitment could also restrict the central banks' freedom to manoeuvre. Economic headwinds can change unexpectedly. A commitment to follow a particular policy stance would limit the central bank's ability to change track in response to emergent trends. Any such abrupt deviation from its pre-announced policy stance would erode the credibility of future announcements by the central bank.

In other words, while anchoring expectations by announcing a commitment to maintaining interest rates during recessionary and uncertain times may be desirable, it may not be wise to institutionalize such medium to long-term commitments into the monetary policy framework of central banks.

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