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Fed Policy Outlook – More Communication Is Good

Contributed by Raymond James

By Scott J Brown

The Federal Open Market meets next week to set monetary policy. It’s widely expected that short-term interest rates will remain unchanged and that (for the time being) there won’t be another round of asset purchases (QE3). The Fed will begin publishing the range of senior Fed officials’ projections of the appropriate federal funds rate target (for the fourth quarter of this year and the next few years). There are more benefits than risks in making these projections public.

After heating up in the first half of 2011, inflationary pressures have receded in recent months. Inflation expectations remain well-anchored and there is still a large amount of slack in the job market, which should severely limit any inflation pressure coming from labor.

U.S. economic growth is expected to be moderate in 2012, but there are continued headwinds and some downside risks. Europe remains the largest concern. Opinions about Europe vary, but the most common view is that the region will muddle along with a mild recession. It’s a bit of a game of chicken. Leaders are doing just enough to prevent a collapse, but not so much that Greece, Italy, and others can avoid making structural reforms. The European Central Bank continues to insist that it is not the lender of last resort. Yet, the ECB has also purchased Spanish and Italian bonds, pushing yields down and easing concerns that these countries won’t be able to roll over their existing debt. However, there is still some chance of a more dramatic deterioration in Europe. That decline would, in turn, have implications for Asia and emerging markets. The IMF is expected to lower its global economic outlook later this month. The risks to the outlook remain tilted to the downside.

A mild European recession would not have a major impact on the U.S. However, policymakers here would not be able to insulate the U.S from the impact of a more dramatic global slowdown. This outlook suggests that the Fed need not act just yet in response to Europe, but must be prepared to do more if conditions evolve in a less favorably manner.

Housing has been a major disappointment for the Fed. Officials thought that the housing recovery would be further along at this point. Residential homebuilding itself is a relatively small part of the overall economy – roughly 4% of GDP in normal times, 6% of GDP during the boom, and roughly 2% recently. However, depressed home prices have a negative impact on consumer spending. More importantly for the Fed, the weak housing market is mucking up the transmission mechanism for monetary policy. The Fed has helped engineer record lows in mortgage rates, but housing hasn’t caught fire. The Fed’s recent white paper on housing was another effort to get Congress to provide more support for the housing market. However, loan modifications and other proposed efforts are likely to only provide a mild lift to housing. These options, even if taken all together, would not be expected to turn the housing market around dramatically, but every little bit helps.

With a low inflation outlook and a continued high level of slack, the Fed has the scope to do more. A number of Fed officials have spoken in the last few months about the possibility of another round of asset purchases, centered in mortgage-backed securities. The minutes of the December 13 policy meeting showed that “a number of members indicated that current and prospective economic conditions could well warrant additional policy accommodation, but they believed that any additional actions would be more effective if accompanied by enhanced communication about the committee's longer-run economic goals and policy framework.” We will have such enhanced communications at this policy meeting.

The Fed will now publish projections of the federal funds target rate and provide qualitative guidance on the Fed’s balance sheet. In addition, the Fed will provide a narrative describing the key factors underlying those assessments. Releasing the federal funds target rate projections of senior Fed officials brings some risks. There’s some chance that financial markets might misinterpret these projections as a hard commitment, with some potential loss of credibility if the Fed has to chance course later on. There’s a risk of the financial markets over-reacting to minor changes in the Fed’s outlook. However, there are more perceived benefits for the Fed. Given a range of projections (high, low, and central tendency), policy would be seen as not being the will of a single individual, but more correctly, as a group decision. Published projections of the federal funds target rate should enhance the continuity and coherence of monetary policy and encourage broader support for prevailing policies. The Fed has a lot to learn about how this will work in practice (granted, not much of this matters now that short-term rates are expected to remain unchanged for a long time).

In the past, the Fed has often used vagueness as a policy tool. For example, officials may have been at times uncertain of whether to raise or lower short-term interest rates. The Fed could hint of policy changes and let the bond market do the heavy lifting, and then if the policy move proved unwarranted, the Fed could hold off. Former Fed Chairman Greenspan was adept at this, although communications improved significantly under his stewardship. The Bernanke Fed set an early goal of even greater communication. The markets haven’t always heard correctly what Bernanke has said and increased public debate among senior Fed officials hasn’t always been helpful (adding to market volatility). However, more communication is better.