Tomorrow the FOMC will embark upon its new communications strategy, by which it will release information on the interest-rate path, consistent with achieving its dual mandate of low inflation and low unemployment. As always, the devil is in the details; and we will explore some of the gotchas that may result, depending upon which of the many possible scenarios they choose. But first, it is important to correct a misperception being perpetuated in the press when they state that the FOMC will reveal its interest-rate “forecast(s).” Since the FOMC sets the short-term Federal Funds target, its inflation, unemployment, and GDP forecasts are conditional upon the path its sets or that is assumed. The FOMC is not “forecasting” the Federal Funds rate. Each committee participant is instructed to assume the path consistent with the committee’s longer-run objectives and then provide forecasts of GDP, inflation, and unemployment.
So what are the possible options as to how the FOMC might choose to release the interest-rate information? The options entail two different dimensions, involving the amount of detail provided and the frequency of the data released (i.e., quarterly, annually, etc.).
In terms of detail, the committee might choose to provide a consensus path, the individual paths assumed by each participant, and/or a fan chart, similar to those released by other central banks, like the Riksbank of Sweden. The Riksbank provides the mean path and probability ranges around that path. The analogy for the FOMC would be to provide the central tendency of the path and range, similarly to what it does now for GDP, inflation, and unemployment.
But right now, the FOMC only provides yearly forecasts for both GDP and inflation while unemployment rate is the rate expected to prevail at the end of the year. If the frequency of those releases doesn’t change, then the FOMC could choose to provide the Funds rate assumed to be in place at the end of the forecast year, or it could provide the average over the year. Neither one of these is likely to be particularly informative, nor would it avoid creating confusion in the market. For example, the FOMC embarked upon a slow and steady path of increasing the Funds rate by 25 basis points for 18 consecutive meetings beginning in June 2003. If in June the FOMC had provided data to the market suggesting that the Funds rate would be 125 basis points higher at year end and would at that same time be 325 basis points higher by the end of 2004 and 425 basis points higher by the end of 2006, it is likely that the performance of the economy and path for market rates would have been substantially different from what they turned out to be. Clearly, if the market had been appraised of the likely path for policy, all the smart money would have shortened durations, the term structure would have flattened, and short-term rates would have risen more than long-term rates, which likely would have moved up sharply as well. The shock to markets would have been huge. Now, it isn’t likely that the FOMC would have had perfect foresight, as most of the models it employs assume about both market participants and policy makers, with respect to the path that was subsequently followed, so periodic changes would have surprised markets. The end result would have been more volatility and uncertainty rather than useful information.
Two other points are critical. First, there would have been lots of different ways to get to a 125-basis-point increase in rates by year-end 2004, and as far as market participants are concerned the path is critical. For example, if markets had known that rates would move by only 25 basis points per meeting, they likely would have responded much differently than if rates had simply moved up in different increments and at meetings than at others. Another source of uncertainty is likely to be introduced by the new policy, related to its conditional nature. President Plosser, for example, has continually emphasised that the future path for the Federal Funds rate is conditional on realisation of GDP, inflation, and unemployment levels. Intermeeting upside or downside surprises, for example, might require a revision in the assumed path for rates, which might then call for either a deviation from the short-term path previously identified or an adjustment in the longer-term path with no change in the short-term policy. In this case the logical question for market participants to ponder is how much of a short-term deviation from the expected paths for inflation, unemployment, and/or GDP would be sufficient to cause the FOMC to revise policy and the policy path it assumed.
The less frequent the forecast revisions and the less detail provided about the intermeeting forecasts for the key variables of interest, the more uncertainty that is likely to prevail. Since the FOMC does meet eight times a year, and twice within each quarter, it would seem logical to provide at least quarterly forecasts for the key variables, rather than simply annualized data. Changing both the frequency of the forecasts and when they are provided would suggest that they should be updated at each FOMC meeting and released, with quarterly annualized estimates to match how GDP data are provided.
There has been the suggestion that the paths assumed by each participant might be released. There are three issues here. First, since only five reserve bank presidents vote, along with the current five governors (normally seven), it becomes critical to know, not the average path or the range of possible paths, but rather the paths of those actually voting. Clearly, given the present make-up of the committee, not all would have the same set of policy assumptions nor the same reactions to deviations of key variables from the forecasts. If individual forecasts are provided, then it is also important to be able to identify the assumed rate path with the projections for GDP, inflation, and employment. Without that information, knowing the rate path is of little use.
One could go on and on and spin different scenarios and cite problems with the alternative disclosures the FOMC is about to make. Whether the information provided will be useful or not, and whether it will reduce or add to uncertainty, remains to be seen. One thing is for certain: Chairman Greenspan was always very cautious about changing how policy was revealed or modifying the FOMC’s communications; because he emphasised that, once done, the change could never be undone, so it had better be right.