January 31, 2006

Greenspan’s many words seldom led to clarification

By James W. Coons

Question from the backseat: "Are we there yet?"

Answer from the driver: "We are proceeding at a measured pace toward our ultimate destination. And we’ll get back to you with more information in about six weeks."

Try that on your impatient little passengers and see if it flies. Expect confusion and insubordination. Yet this is essentially what the Federal Reserve Board has been saying during its march toward higher interest rates. Why are people applauding the Fed for more open communication?

Chairman Alan Greenspan & Co. are poised to raise the target for its overnight interest rate this afternoon for the 14 th time in as many meetings. The total increase of 3.5 percentage points has been the model of smoothness – one-quarter point about every six weeks. Along the way, the Fed has shared its deepest thoughts on monetary policy in post-meeting communiqués and meeting minutes. The result has been ongoing confusion. This is no way to run monetary policy.

Greenspan does deserve credit for opening up the Fed. People joke about his complicated and lengthy statements. In fact, "Greenspanspeak" is sparkling spring water compared to the murky brew of his predecessor, Paul Volcker. Greenspan also instituted key reforms: announcing the results of meetings and speeding up the release of meeting minutes and transcripts. In congressional testimony, he has delivered insightful lectures on macroeconomics and monetary policy. So why the criticism?

The Fed has said too much without communicating. The motivation is to avoid surprising investors, who make decisions based on expectations. Those decisions can yield huge financial losses if expectations prove inaccurate. Large enough losses can destabilize the financial system, hurting innocent bystanders. Ergo, communication with market participants can prevent market disasters.

The problem is that policymakers cannot tell us where interest rates are headed beyond the next few months, because they do not know. And talking in great detail with great frequency about the unknowable breeds confusion.

“More words don’t necessarily create more clarity,” according to William Poole, president of the Federal Reserve Bank of St. Louis. “Fed actions are based on economic developments that the Fed isn’t any better at forecasting than the markets. If the Fed did talk about future moves, it could well be wrong and mislead the public.”

The president of the Federal Reserve Bank of Dallas said last summer that the current phase of rising interest rates is in the eighth inning. Presumably, he meant that the Fed was almost finished raising rates. That was six increases and 1.5 percentage points ago. Did he forget to say it was a double-header?

Against this backdrop of uncertainty, what are investors to make of statements by policymakers that the Fed can “be patient” for a “considerable period” before lifting rates at a “measured pace” until “policy accommodation” has been removed? All, of course, depending on “changes in economic prospects.”

How refreshing and enlightening it would be if the Fed simply said that its objective is inflation between 1 percent and 2 percent, for example. Better yet, what about targeting zero percent? Even inflation of only 2 percent annually reduces the purchasing power of a dollar by nearly 20 cents in 10 years.

The Fed could specify how inflation would be measured and what would be considered a serious deviation from the target. When investors asked, "Are we there yet?" the answer would lie in the proximity of actual inflation to the target, not in a possibly misleading pronouncement.

A common criticism of inflation targeting is that it would reduce the flexibility of the Fed to react to a sudden weakening of employment and production. Quite the opposite, the existence of an inflation target and a track record of hitting it would permit the Fed to respond more aggressively to fluctuations in the economy without creating concerns that inflation would be allowed to rise.

Ben Bernanke, the incoming Fed chairman, is a proponent of inflation targeting, but believes that it should be teamed with frequent and detailed communication. Investors might keep asking, "Are we there yet?" for some time to come.

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