The FOMC surprised most economists after its December meeting, not with its decision to extend its MBS purchases or to expand its long-term Treasury purchases, but with the changes to its communications strategy. What the FOMC said in its statement was that it would keep its zero interest rate policy as long as the unemployment rate remained above 6.5 percent, provided its inflation forecast one to two years out for inflation stayed below 2.5% and longer-run inflation expectations remained “well anchored.”
While the statement seems relatively clear at first blush, Chairman Bernanke’s elaboration of the changes during his press conference indicated that the policy was filled with nuance and conditionality not fully appreciated by pundits or the press, and that there had been some backpedaling on the key inflation measure upon which the FOMC was conditioning its policies. Bernanke indicated that in addition to the unemployment rate, the Committee would also look at many other indicators of employment and labor-market conditions that might affect its policy decision. The Committee might not be inclined to act, for example, if unemployment dipped below the target because a large number of people had suddenly exited the labor market. He also indicated that the Committee intended to look through what it viewed as temporary, or transitory, price increases, and that this was part of the rationale for its one- to two-year time horizon.
As one digests the Fed’s adoption of specific targets that might trigger policy moves, things become messy indeed. The first logical question, since the change is to be based upon a forecast, is, exactly whose forecast will be used to judge whether the inflation forecast was above the 2.5% trigger? Chairman Bernanke indicated that the Committee would look at not only its own forecasts but those of professional forecasters, as well as other market indicators. So instead of providing a clear indication of whose forecasts would be the ones relied upon – for example, its own forecasts presented four times a year – the Committee chose to fuzz up the issue by indicating it would consider many different forecasts. This means that the Committee can cherry pick whatever forecast it chooses to justify either making or not making a policy move; and ex anti, the public will be forced to guess as to which forecasts may or may not be in favor and relied upon by the FOMC. Professional forecasters will certainly be hyping their forecasts and past performance as they vie for public attention. This is not a positive step towards policymaking transparency.
It is particularly interesting that the Committee’s own forecasts were not specifically selected as the ones to be relied upon. Perhaps this is because the Committee has failed in its experimental efforts to construct a consensus forecast. And it probably failed because there is neither agreement among FOMC participants as to what the appropriate assumptions should be about the future path of policy, nor is there much consistency in the models used and the forecasts produced.
As an aside, it is virtually impossible for the individual governors to produce the kinds of sophisticated forecasts that the Fed staff produces, since the governors don’t have their own independent staffs. This suggests that the governors’ forecasts are likely to be highly collinear with those of the staff, while the Reserve Bank presidents’ forecasts are more heterogeneous and independent, because each has his or her own staff economists who prepare separate forecasts with often differing views about the structure of the economy and its dynamics. This situation gives the seven governors and, by implication, the Board’s staff an even more dominant position in policymaking than the formal structure of the FOMC, with its seven governors and five Reserve Bank presidents, might suggest. The question then becomes, whose forecasts are more accurate, those of the Board’s staff or those of one or more of the Reserve Bank presidents?
The second logical question is what criteria will be used to determine whether inflation expectations are “well anchored?” Will that be triggered by a particular change in measures of inflation expectations by professional forecasters, by surveys, or by a change in estimates of inflation expectations extracted from the term structure? How much of a change needs to be observed before concluding that expectations are no longer “well anchored?”
In light of the FOMC’s new communications strategy, market participants will be incented to devote significant resources to monitoring labor-market conditions and inflation forecasts, since fortunes depend upon front running FOMC policy moves. Who, for example, wants to be long MBS when the Fed ceases its purchases, or who wants to be invested in fixed-income securities when rates start to rise?
The key for investors lies in obtaining credible, high-quality forecasts and intelligence about labor-market conditions and inflation that approximate, or are better than, those relied upon by the FOMC. Predicting unemployment is relatively easy, because the unemployment rate changes very slowly. The mean change in the monthly unemployment rate from January 1950 through November 2012 was just .0016, with a standard deviation of 20 basis points and a mean absolute deviation of 14 basis points. In many models, the best forecast of next month’s unemployment is simply that of the past month.
The really troublesome issue centers on the reliance upon inflation forecasts one to two years out. First of all, is the critical time horizon one year or two years? There is a big difference! The chairman, in his press conference, indicated that forecasts of inflation become suspect after only a few quarters. In addition, work by myself and former colleagues at the Atlanta Fed demonstrated that it is extremely difficult for a forecaster to be right consistently in forecasting the key economic variables. Even the best forecasters have relatively high error rates with even their short- and intermediate-term forecasts. Their forecasts may be dead on one quarter and way off for the next quarter. Figuring out who is right and when isn’t easy.
So, the key question is whether this change in communications has helped markets participants or simply added to uncertainty. The change clearly shows us what factors to look at, but we knew those before the change. But what it hasn’t done is tell us how the Committee will weigh the various measures of labor-market conditions or what inflation forecasts will be given more or less weight when it comes to decision time.
With so much money riding on the FOMC’s decisions, the switch back to core inflation, for example, is a puzzle – if in fact that change was actually made – and requires more attention. Headline inflation is more volatile than core PCE, and skeptics might conclude that the change back was a backdoor way of indicating that the Fed might have a greater tolerance for short-term deviations in the more volatile headline PCE inflation index than the 2.5% core PCE tolerance number mentioned might imply. I would also note that not one policy maker deviated from a 2% forecast for inflation over the longer run, and the Committee doesn’t even provide forecasts for core PCE over the longer run.
The Committee’s choice of the one to two year time period also suggests that the projection materials, to be useful will have to add a separate set of projections for one year and two years in order to separate their hope, or target for inflation, from the reality of where it actually is.
In addition, the change in communications policy begs for more frequent forecasts by the FOMC. Preferably, forecasts would be produced and released at every FOMC meeting. Consider the difficulty the FOMC will face the first time it has to change policy following a meeting in which forecasts are not made or not made public. This doesn’t seem like a positive development when it comes to the Fed’s transparency objective.
Several things are now more clear, however. First, the demand for both Fed staff who involved in the forecasting process and the output of the best private-sector forecasters has just gone up significantly. Beware of those touting recent forecasting success! Look for consistent performance. Research shows that consensus measures and the averaging of several forecasts tend to be better than relying upon any one forecaster.
Second, even more attention will now be paid to speeches by both bank presidents and the governors, as people seek clues to determine how each views labor-market conditions and the inflation outlook. Third, the pressure for more frequent FOMC forecasts should be heightened. Fourth, one should expect a great deal of speculation in financial markets in long and short MBS and bond positions, and hedging against upward movements in rates will become preeminent. For this reason, market participants should expect sharp upward movements in rates once there is even a hint of a policy move. And these hints will now be based more upon publicly available forecasts rather than Fed forecasts. Finally, the FOMC should not be surprised if it is constantly placed in the position of having to ratify forecasts with policy moves, to maintain credibility. Disappointing markets with detailed ex post rationales and explanations as to why policy moves weren’t delivered as expected or as indicated by the FOMC’s crude numerical targets will destroy credibility and the FOMC’s ability to act independently.