Alford: Fed Talk As Policy

By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

The Fed believes that it has succeeded in making monetary policy significantly more transparent. Furthermore, the Fed believes that by being transparent it can influence market expectations and the behavior of the real economy. This is the basis for the emphasis on “talk as policy”.

However, one can ask: has rhetorical guidance regarding the Fed funds target made policy significantly more transparent than in the past? Assume for the moment that, in an effort to make its next statement less repetitive, the Committee decided to replace the word “extended” with a synonym – “prolonged” Is there any doubt that the markets would react to the changing of the word “extended”, even if it was only to replace with one of its synonyms?

In this context, it seems to me that one might reasonably ask:

1) If policy is so transparent, why should the market care one iota if the FOMC were to substitute “prolonged” for “extended” or to replace any other word in any of its communications with a synonym?

2) Has the use of “code” words in FOMC statements increased policy transparency, or simply reduced the uncertainty about the near-term course of short-term interest rates?

The detailed parsing of FOMC statements and minutes by Fed watchers reminds me of the analyses produced by Kremlinologists and Sinologist during the height of the Cold War. Limited in their ability to do any real analysis of developments in Russia and China, Kremlinologists and Sinologists carried out careful textual analysis of the public pronouncements of the relevant political leaders. Great importance was attached to the most miniscule changes in statements, e.g., an out-of-favor former official who had previously been described as a revisionist dog suddenly being described as a running revisionist dog. This form of usually meaningless “analysis” waned after the Cold war ended and analysts had access to real information.

The Fed cares about policy transparency, but the markets care about and want certainty regarding the future course of interest rates. The Fed has made it clear that it is targeting inflation using a Taylor Rule construct. Does micro managing volatility in the Fed funds market via code words make policy formulation more transparent? Is using “talk” to dampen uncertainty in the Fed funds market necessary to achieve policy transparency? Providing transparency about the policy formation process does not eliminate uncertainty about the future course of interest rates. The Fed, however, has come to view reduced uncertainty about the near term course for the Fed funds target as a necessary component and measure of policy transparency.

The market seems to enjoy the reduced uncertainty. However, if there are benefits to the Fed providing verbal guidance about the near term course of policy, there are also costs. Reduced uncertainty about the future course of the Fed funds rate potentially makes economic agents more willing to employ leverage and run maturity mismatches. In point of fact, increasing the use of maturity mismatches may currently be a goal of policy. However, the slow and overly telegraphed tightening cycle post 2003 almost certainly contributed to the excessive use of leverage and the maturity mismatches which supported the housing bubble. It is entirely possible that someday the FOMC will be forced to delay or alter the targeted path for the Fed funds rate because the desired adjustment of policy would be too big a shock for the markets. Surprises do happen.

If the Fed gets policy right, then any increased uncertainty about the near term course of the Fed funds rate would be a non-issue. If the Fed sets policy incorrectly, no one will care about the increased volatility in the Fed funds rates either. The economy, the markets and the Fed would be better off if the Fed stopped its editorial hand holding and encouraged economists inside and outside the Fed to spend their time and energy focusing on the economy and the financial markets instead of the thesaurus.