The below is from the FT’s Money Supply blog that covers all things central banky.
So the Federal Reserve on Wednesday will publish forecasts which will show us how long it plans to keep rates at more-or-less zero. Hasn’t it done that already?
Sort of. The voting members of the Federal Open Market Committee, which is responsible for setting interest rates, have already committed to keep rates at their current record lows until at least the middle of next year.
The move to produce interest rate forecasts however is a slightly different, slightly bolder step.
How so?
In a couple of ways.
First, it will extend the horizon out past mid 2013 to the end of 2016.
Second, the quarterly forecasts for interest rates, like those for inflation, growth and employment, will allow us to see the opinions of all the committee members, not just the voting members.
The Federal Reserve’s board of governors is two short of its full complement of seven at the moment. But usually the majority of the voting members are from the Washington-based board. Bar the head of the more influential New York Fed who always votes, only four of the 12 regional Fed presidents can vote at any one time.
By taking on board the views of the entire committee, the forecasts shift the balance of power slightly from the Washington-New York nexus to the regional Feds. This is interesting because dissent more often than not comes from the regional Fed presidents.
So will the forecasts shed more light on what the hawks and doves are thinking?
Yes. At the moment there are four hawks, all of whom come from the regional Feds and of whom only two will be voting members at this week’s meeting. There is also one out-and-out dove in the form of Chicago Fed president Charles Evans.
The forecasts come in two parts: a chart on the appropriate timing of rate hikes and a chart on the appropriate pace of rate hikes. Both record the votes of individual members, allowing us to see how out of line with the consensus the views of the dissenters actually are. (See this post by Robin Harding on how the forecasts will look).
So there’s a lot more information contained in the interest rate forecasts than you get with the conditional commitment.
Yes. But perhaps the biggest difference is that, unlike the commitment to keep rates at their current record lows, the quarterly forecasts are set to outlive the financial crisis.
But how on earth can the Fed know where interest rates will be several years from now?
They can’t. At least not with any reasonable degree of certainty. As Svante Öberg, deputy governor of Sweden’s Riksbank, has recently noted, central bank forecasts are pretty useless for anything more than a year out.
Nevertheless, the vast majority of central banks consider it their duty to forecast growth and inflation. In theory then, there’s no reason why central banks shouldn’t also forecast what they think will happen to interest rates. Especially given that policymakers largely base their interest rate decisions on where they expect growth and inflation to be in future.
Some – including the Riksbank, Norges Bank, the Reserve Bank of New Zealand, and the Czech National Bank already do so.
Besides, if you’re concerned about uncertainty, you can always do what the Riksbank does and say that what you expect to happen to interest rates is a “forecast not a promise”. Note that the Fed too has been very clear to state that its commitment to keep the federal funds target range between 0 and 0.25 per cent is contingent on inflation remaining reasonably low and the US economy weak.
Why is the Fed bothering to do this?
It’s best to look at this both in terms of what the Fed hopes to achieve in the short term and what chairman Ben Bernanke’s own opinions on the best way to ‘do’ central banking are.
The Fed’s near term concern is around the breakdown in monetary transmission, aka the plumbing through which the rate the central bank sets is passed on to borrowers.
At present, the Federal Reserve’s ultra-low rates are not spurring as much of a pick-up in lending – and consequently economic growth – as the central bank would like.
With the US economy seemingly on the up, the Fed is reluctant to start more quantitative easing. But some economists believe that telling markets and the public that rates will remain low for a long time yet, will have a similar effect.
How?
In a word, confidence. By committing to keep rates low, the central bank will encourage businesses and households to borrow now by signalling that it will tolerate higher inflation in order to support growth. So fans of the theory say, anyway.
And Ben Bernanke is a fan.
Correct. Less so since joining the Fed, but during his days as a Princeton academic the chairman was a proponent of the view that policymakers can influence people’s inflation expectations through policies such as interest rate forecasts.
So the Fed is hoping that it can solve the US’s economic ills by convincing the public that it should believe them that rates will remain ultra low for a long time? That all sounds a little like jedi economics.
Perhaps. But there is a lot of academic literature to support this claim. And it’s not unreasonable to think that the central bank, as rate-setter and monopoly issuer of the currency, can do a fair bit to influence people’s expectations about the direction in which inflation is heading.
In fact, there’s also a risk that it could work rather too well and inflation expectations could become unhinged.
But in practice, does it actually work?
For those central banks that already producing rate forecasts, the results are not convincing. Recent research into the Riksbank’s rate forecasts suggest markets are less moved by central banks’ commitments on the future path of interest rates than the Swedish central bank, and indeed the Fed, might hope. The problem seems to be that they just don’t buy central banks’ promises, perhaps because their forecasts have been so inaccurate.
However, the research was co-authored by Charles Goodhart, who has long favoured projections on the future path of interest rates based on market expectations rather than those of central bankers.
The way in which the Fed’s rate forecasts are designed is also likely to lessen any impact that they might have.
Why?
The Riksbank’s forecasts show the consensus among committee members, and are therefore a pretty good indicator of what the committee would do with interest rates so long as inflation and growth move in line with expectations.
The Fed’s forecasts, on the other hand, represent what each member would personally do, not what they think actually will happen to policy.
To boot, the hawks, unwilling to tolerate higher inflation, hold more sway over the interest rate forecasts than the Fed’s current conditional commitment. They are likely to want rates to be raised at the merest hint that inflation could spiral. That could mean that the forecasts are not as effective as the conditional commitment, which represents the far more dovish consensus view, in convincing the public that the Fed would tolerate relatively high inflation in order to support growth.
Sounds as though the Fed is clutching at straws.
Only time will tell. What’s clear already though is that, unless the Fed opts to give more quantitative easing — or something more radical — a try, there’s little else it can do to lower the cost of borrowing.
Related links:
What the FOMC’s rate forecasts will look like – FT Money Supply
Fed to reveal almost all – FT Money Supply
Fed to publish fed funds rate projections – FT Alphaville
Fed Thoughts: The End of History? (pdf) – Vincent Reinhart of Morgan Stanley