1.05.2012

Fed Forecasting: Transparency or Risky Monetary Tool

Any observer of the financial markets around the turn of the century will remember a bewildering assortment of obfuscations by then Federal Reserve Bank Chairman Alan Greenspan. In what amounted to a cat and mouse game between the interest rate-setting body of the world's largest economy and the credit and equity markets dependent on its edicts, Greenspan seemed to delight in delivering a turn of phrase which kept investors on their toes.

When Ben Bernanke took over in 2006, he vowed to diverge from this strategy and promised to usher in a new era of transparency. He has succeeded in this endeavor in increments, first employing clarity in Fed meeting minutes, then mimicking this approach in everything from congressional hearings to informal dinner speeches. In a recent announcement which seemed to be missed by many in the media, he laid the foundation for a continuation of this long-term strategy of transparency when he announced that the Fed will begin publishing its own forecasts of interest rates up to a few calendar years in the future.

While this is certainly in keeping with his trend of pulling back the Fed's traditional veil of mystery, it also begs a number of questions. For example, is the plan intended to increase transparency, or is it n reality intended to serve as a tool to reduce long-term interest rates? Perhaps both? Is the latter merely a corollary of the former? If it is actually intended more as a subtle rate reduction tool, does this mean that the Fed is feeling for the last few bullets in its belt?

If it is indeed a ploy to increase clarity behind Fed strategy and decisions, it could help those involved in credits markets in long-term planning. This, in turn, could have the effect of reducing long-term rates. While these could both potentially be positives, it is also true that it is in the Fed's interest to maintain some level of secrecy as well.

For example, it is a near certainty that markets will price in the information which will be in the published forecasts. This includes long-term debt instruments, which, as anticipated above, will have a reduced risk premium owing to the increased visibility into Fed strategy. However, the Fed will reserve the right to change its forecasts on a dime. If such a change occurs (particularly the first time or so that it does) it could create more volatility in the markets than there would have been if they didn't have the information in the first place. Shame on the market participants one might say; but then it would be even more foolish if they didn't take Fed-provided forecasts under advisement, particularly when their peers are.

It also seems as if this type of strategy could invite currency manipulation by foreign banks and governments. For example, if a nation with a non-floating currency, large treasury holdings and strong trade ties to the US had a very strong indication that interest rates would not move for, say, three years, it would be even easier for it to ensure that it kept its goods flowing solidly in one direction. Whether or not this is ultimately bad is a matter for debate, but it should nonetheless be part of the conversation.

Longer-term implications exist as well. Some Fed officials indicated fears that markets could interpret the forecasts as strategy goals, an issue noted above. What if a future Fed chair shares this concern? Will he or she have the flexibility to revert to a less transparent strategic approach if they feel it is necessary? Or will this precedent leave them helpless to shape policy suited to their styles and the times they are operating in.

Time will tell if Chairman Bernanke's approach is the right one. There are certainly benefits to transparency, and there is no doubt he had all of the above concerns in mind, or at least brought to his attention, before he finalized this dramatic policy change. However, if this was merely a means to reduce long-term rates, it seems as if far too much flexibility was taken off the table for what could be a fleeting benefit fraught with risks.

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