The Federal Reserve has gotten plenty of criticism for its recent communications about its monetary policy intentions. For example, Mark Gilbert at Bloomberg complained that "...the forward guidance policy adopted in recent years by many central banks is in tatters, and is probably doing more harm than good in telling companies and consumers when borrowing costs are likely to rise and at how fast."
Edward Luce at the Financial Times had similar sentiments, concluding that "Ms Yellen has juggled with different types of communication. They call this learning by doing. As the next countdown begins, her goal must be to share her thinking more clearly."
Is the Fed guilty as charged, and why is this important?
Let's begin with the importance. Economic theory suggests that when the Fed deviates from what markets expect, it can have a large, undesirable impact on macroeconomic variables and financial markets. Ever since this theory was developed a few decades ago, the Fed has gone to great lengths to be as transparent as possible in its decision-making process to reduce uncertainty about the course of policy.
This is also one reason some economists want the Fed to follow a strict rule in setting policy. In that case, if the rule is well known, it's easy to predict what the Fed will do now and in the future.
However, strict rules can go awry in unusual times, such as the Great Recession when creative policy solutions are needed. That makes the costs and benefits of the "rules" approach less than clear. (Legislation has been introduced that would force the Fed to use a rule to set policy, but it would also allow deviations when the Fed thinks that's needed -- a policy regime known as "constrained discretion.") In any case, the Fed does its best to avoid surprises.
But sometimes surprises are unavoidable. When widespread agreement exists about economic conditions, and therefore the course of policy, communication is easy. The markets already know what to expect simply by looking at macroeconomic data (e.g. the economy is overheating).
But disagreement reigns when opinions differ, for instance, about the state of labor markets and the potential for inflation, and therefore for the course of policy. And it's best for markets to understand the extent of the disagreement.
For example, suppose the chances are 50-50 that rates will go up by a quarter percent at the next Fed policy meeting. Some members of the central bank's policy-setting Fed Open Market Committee (FOMC) are on the fence, the others line up equally on both sides, and prior to the meeting the outcome is a toss-up.
However, if markets are fairly certain rates will go up based on Fed communications, and rates end up staying unchanged, that's a much bigger surprise than if investors knew the chance was 50-50.
The result is quite general, and the point is quite simple: If the Fed is split, say, 60 percent to 40 percent on a rate increase, markets will, on average, be less surprised the more precisely they know these chances. A false, unified front from the Fed is counterproductive.
Is that what the Fed has done? Has it presented itself as more unified on a rate hike than it actually is? Did it signal a rigid liftoff date that would change only if data came in with very large surprises? Or did the FOMC members have more disagreement and more sensitivity to incoming data than we were led to believe?
Prior to the last Fed meeting, some committee members were very vocal about their view that rates need to stay low through at least 2015. Charles Evans, president of the Chicago Fed, and Narayana Kocherlakota, president of the Minnesota Fed, are two prominent examples. Plenty of signals were coming from many other Fed members that they were far from certain about the appropriate time to begin raising rates.
And the message was received. Two surveys of economists prior to the last FOMC meeting showed a split almost exactly 50-50 on the chances of a rate hike. So, while some people may have heard what they wanted to hear, the idea that the public was falsely led to believe the Fed was unified on a rigid course to the liftoff date doesn't seem to be supported.
Now, let's look at the other question: Is the Fed more sensitive to incoming data than we thought? Yellen & Co. have always said policy is data-dependent. The Fed repeats that every chance it gets. So, when the FOMC is actually data-dependent -- when events in China and other parts of the world send up caution flags and inflation is less of a problem than anticipated -- we shouldn't be so surprised if the Fed responds accordingly.
Markets seemed to believe the Fed was on a fixed course to a September rate hike -- damn the data torpedoes, full speed ahead -- or nearly so, and they were surprised when the Fed strayed from the course they thought it was on.
I think some members of the Fed did take an overly hawkish, deterministic approach to the liftoff date. But given the repeated insistence by most FOMC members, Janet Yellen in particular, that policy would depend on evolving and uncertain economic conditions, it shouldn't have been so surprising that policy actually is data-dependent instead of being etched in stone.
Data-dependence is a good thing: Policy should react to changes in the state of the economy, and markets can adjust their expectations accordingly in the future.
I don't mean to argue that Fed communications were perfect -- far from it. I think too much talk about particular liftoff dates has been translated into more certainty than was actually present on the FOMC. The belief that the Fed was on a fairly rigid course, in turn, led to the belief that incoming data wouldn't much matter unless it was really bad.
I also believe the Fed's data-dependent path began from an overly optimistic outlook, and that caused it to set forth a more hawkish path (meaning it wouldn't wait to raise rates) than could be sustained as more data arrived. When the path couldn't be sustained, it looked like a messaging problem.
But the far bigger issue was the Fed's overly rosy picture of where the economy would be by this time, a problem it has had throughout the Great Recession and subsequent recovery.
Clear messages about an intention that's unlikely to be fulfilled will always be problematic. Thus, the real snafu has been with the Fed's forecasts. The central bank's continuing tendency to base policy intentions on overly optimistic projections of the economy's future course is what I'd like to see fixed.