Does anybody believe the risks to the US economy are balanced between higher inflation and weaker growth? If they are, why is the overnight federal funds rate at a microscopic 1.25 percent? The inconsistency between what the Federal Reserve says and does was driven home yesterday in its statement following a regular policy meeting.
The Fed lowered the funds rate by a bigger-than-expected 50 basis points, and in an apparent effort to convey to the markets, "no mas," it tacked on a statement claiming future risks are balanced.
Yet another tool for improved communication and increased transparency has fallen victim to Fed tinkering.
"They're back to their old tricks," says Jim Glassman, senior US economist at J.P. Morgan Chase & Co.
For those of you who may be a little rusty on your Fed policy procedure history, the balance-of-risks statement replaced the inter-meeting directive in February 2000 "to enhance communication to the public" and alleviate "unanticipated confusion" in the markets. The policy directive had been incorporated into the Fed's instant-release policy in May 1999; the immediate announcement of the policy action following each meeting was implemented in February 1994.
The directive, rightly or wrongly, was viewed as an expression of the likelihood and direction of an inter-meeting move. The Fed wanted to get away from providing a near-term trading incentive and convey a longer-term outlook, expressed in the context of the balance of risks "to the attainment of its long-run goals of stable prices and sustainable economic growth." It didn't take long for the new policy to become a bargaining chip to achieve a consensus on the rate action and a means of conveying something other than a longer-term outlook.
For example, at the Mar. 19 meeting, policy makers acknowledged that "the stance of policy would need to be adjusted at some point to provide less stimulus" -- a cumbersome way of saying rates will have to rise. In the committee's view, a 1.75 percent overnight rate was inconsistent over time with maintaining price stability, one of the Fed's two mandates. Wouldn't higher inflation at the current rate level qualify as the long-term risk? In the near term, "significant downside risks remained." How to reconcile the two? Slap together a statement saying the risks are balanced, which hardly communicates the nature and timing of the offsetting risks.
The Fed keeps trying to fit a round peg into a square hole.
It says it wants to convey information, but what it is really trying to do is control expectations and manage results. That's a tall order for a single sentence.
Any one-size-fits-all policy procedure is almost destined to fail. When the cleansed minutes of yesterday's meeting are released on Dec. 12, they may reveal some members of the committee opposed to a 50 basis-point rate cut even in the face of a stall in economic activity.
After all, the Fed preaches that monetary policy operates with a nine- to 18-month lag.
A big rate cut now accompanied by an unsubtle message killing expectations of another one anytime soon sounds like the best compromise consensus-building Fed Chairman Alan Greenspan could pull out of his hat. It is a compromise appealing to everyone, satisfying no one.
The inherent contradictions between word and deed probably do more to hurt the markets than help. A balanced risk assessment conveys confidence in the outlook. A 50 basis-point rate cut conveys no confidence.
The Fed isn't constrained by the balance-of-risks statement.
It has the ability to communicate anything it wants clearly in a carefully crafted press release. Surely the Fed has some good editors to assist in this endeavor.
Financial markets operate most efficiently when all known information is conveyed honestly and clearly. The future, by definition, is never knowable. At a minimum, then, it helps to be clear about what you think the future holds.
Central banks talk about the importance of great transparency all the time. It's time they started to practice what they preach.
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