The Fed’s com­mu­ni­ca­tion breakdown

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In other words, the Fed’s com­mu­ni­ca­tion strat­egy is a mess, and clean­ing it up is far more im­por­tant than the ex­act tim­ing of the FOMC’s de­ci­sion to exit near-zero in­ter­est rates. Af­ter all, even af­ter the Fed does fi­nally make the “gi­gan­tic” leap from an ef­fec­tive fed­eral funds rate of 0.13% (where it is now) to 0.25% (where is likely headed soon), the mar­ket will still want to know what the strat­egy is af­ter that. And I fear that we will con­tinue to have no idea.

To be fair, de­cid­ing what to do is a very tough call, and econ­o­mists are deeply di­vided on the mat­ter. The In­ter­na­tional Mone­tary Fund has weighed in force­fully, call­ing on the Fed to wait longer be­fore rais­ing rates. And yet cen­tral bankers in the very emerg­ing mar­kets that the IMF is sup­pos­edly pro­tect­ing have been send­ing an equally force­ful mes­sage: Get on with it; the un­cer­tainty is killing us.

Per­son­ally, I would prob­a­bly err on the side of wait­ing longer and ac­cept the very high risk that, when in­fla­tion does rise, it will do so briskly, re­quir­ing a steeper path of in­ter­e­strate hikes later. But if the Fed goes that route, it needs to say clearly that it is de­lib­er­ately risk­ing an in­fla­tion over­shoot. The case for wait­ing is that we re­ally have no idea of what the equi­lib­rium real (in­fla­tion-ad­justed) pol­icy in­ter­est rate is right now, and as such, need a clear sig­nal on price growth be­fore mov­ing.

But only a foam­ing polemi­cist would deny that there is also a case for hik­ing rates sooner, as long as the Fed doesn’t throw ran­dom noise into the mar­ket by con­tin­u­ing to send spec­tac­u­larly mixed sig­nals about its be­liefs and ob­jec­tives. Af­ter all, the US econ­omy is at or near full em­ploy­ment, and do­mes­tic de­mand is grow­ing solidly.

While the Fed tries to look past tran­si­tory fluc­tu­a­tions in com­mod­ity prices, it will be hard to ig­nore ris­ing con­sumer in­fla­tion as the huge drop of the past year – par­tic­u­larly in en­ergy prices – sta­bi­lizes or even re­verses. In­deed, any stan­dard de­ci­sion rule used by cen­tral banks by now dic­tates that a hike is long over­due.

But let’s not make the ba­sic mis­take of equat­ing “higher in­ter­est rate” with “high in­ter­est.” To say that 0.25%, or even 1%, is high in this en­vi­ron­ment is pure hy­per­bole. And while one shouldn’t over­state the risks of sus­tained ul­tra-low rates to financial sta­bil­ity, it is also wrong to dis­miss them en­tirely.

With the de­ci­sion about rais­ing rates such a close call, one would think that the Fed would be in­clined to do it this year, given that the chair and vice chair have pretty much told the mar­ket for months that this will hap­pen. The real rea­son for not hik­ing by the end of the year is pub­lic re­la­tions.

Let’s sup­pose the Fed raises in­ter­est rates to 0.25 ba­sis points at its De­cem­ber meet­ing, try­ing its best to send a sooth­ing mes­sage to mar­kets. The most likely out­come is that all will be fine, and the Fed doesn’t re­ally care if a mod­est eq­uity-price cor­rec­tion en­sues. No, the real risk is that, if the Fed starts hik­ing, it will be blamed for ab­so­lutely ev­ery bad thing that hap­pens in the econ­omy for the next six months to a year, which will hap­pen to co­in­cide with the heart of a US pres­i­den­tial elec­tion cam­paign. One small hike and the Fed owns ev­ery bad out­come, no mat­ter what the real cause.

The Fed of course un­der­stands that pretty much ev­ery­one dis­likes in­ter­est-rate hikes and al­most al­ways likes rate cuts. Any cen­tral banker will tell you that he or she gets 99 re­quests for in­ter­e­strate cuts for ev­ery re­quest for a hike, al­most re­gard­less of the sit­u­a­tion. The best de­fense against th­ese pres­sures is to op­er­ate ac­cord­ing to ut­terly un­am­bigu­ous cri­te­ria. In­stead, how­ever good its in­ten­tions, the net ef­fect of too much Fed speak has been vague­ness and un­cer­tainty.

So what should the Fed do? My choice would be to have it ex­plain the case for wait­ing more forthrightly: “Get­ting off the zero bound is hard, we want to see in­fla­tion over 3% to be ab­so­lutely sure, and then we will move with rea­son­able speed to nor­malise.” But I also could live with, “We are wor­ried that if we wait too long, we will have to tighten too hard and too fast.”

Throw­ing out the rule­book made sense in the af­ter­math of the 2008 financial cri­sis. It doesn’t any­more. And to­day’s lack of clar­ity has be­come a ma­jor con­trib­u­tor to mar­ket volatil­ity – the last place the Fed should want to be.

It’s wrong to vil­ify the Fed for hik­ing, and it’s wrong to vil­ify it for not hik­ing; if it is such a close call, it prob­a­bly doesn’t mat­ter so much. But, at this crit­i­cal point, it is fair to ask the Fed for a much clearer mes­sage about what its strat­egy is, and what this im­plies for the fu­ture. If Fed Chair Janet Yellen has to as­sert her will over the FOMC for a while, so be it. Some­body on the com­mit­tee has to lead the camel to wa­ter.

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