The Federal Reserve and the New Transparency

At the conclusion of the FOMC meeting, the usual statement will be issued, but what is capturing the attention of the market is that the Fed will also publish the expected path of the Fed funds rate and the expected timing of the first hike.  

The statement itself is important.  It has become largely formulaic.  The FOMC provides an assessment of the recent economic data.  The Fed here will be somewhat more upbeat.  The recent string of data, including employment, housing and output has generally surprised on the upside.  While acknowledging this, the Fed is likely to continue to warn of downside risks.  

The Fed's inflation assessment needs to be more nuanced.  On one hand headline inflation has fallen quickly from 3.9% (year-over-year) in September to 3.0% in December.  Base effects suggest further declines in headline CPI through the first several months of 2012.  

On the other hand, core inflation continues to rise.  On a year-over-year basis, it has not fallen since October 2010 and appears to be poised to rise further in the coming months.  

Next the FOMC provides an general outlook and this is unlikely to change much.  Growth likely to remain moderate and unemployment only fall gradually.  It will likely continue to recognize the risks posed by strains in the global capital markets.  Although measures of strains have eased in recent weeks, policy makers cannot be be sure the a significant corner has been turned in Europe.  

The last two paragraphs discuss the Fed's actions and these two paragraphs will not change in substance.  The Fed continues to Operation Twist and does not anticipate a change in the Fed funds target.  Last year it put a time frame on that anticipation to middle of 2013.  This could be removed because of the new information the Fed will provide.  

Last week the Fed provided templates of the tables that it will use to provide the expected timing of the hikes and the appropriate pace.  These will the anonymous views of all 17 policy makers.  This is important. It will not only include voting FOMC members, but all the regional presidents as well.  

The new rotation of regional Fed presidents on the FOMC offers a somewhat less hawkish configuration that last year.  Of note, though in the last two meetings of 2011, the dissent came from the dovish Chicago Fed president seeking additional policy accommodation.  

There should be 19 inputs, but there are still two unfilled seat on the Board of Governors.  This puts the Board of Governors in an unusual position of being at parity with the regional presidents.  Five regional presidents vote at the FOMC, four of which rotate with the NY Fed President being a permanent voting member.  The dissents typically come from the regional presidents.  

The Board of Governors is understaffed and all 12 regional presidents will have their forecasts recorded.  This will give the regional presidents a greater weight, but most importantly will show the range of policy views at the Fed.

In the press conference that follows, Bernanke is likely to emphasize that these are forecasts not promises.  He will likely discourage precisely what we did when the Fed first announced these intentions.  We thought that the consensus at the Fed would be for the first rate hike to be anticipated to be appropriate in mid-2014.  We argued that by pushing out the potential move from mid-2013 that this would be tantamount to some easing of policy, when bounded by zero.  

While this logic is still valid, Bernanke is likely to emphasize that the purpose of the exercise was not to announce a new policy but rather to improve the transmission mechanism of the current policy.  

The time period covered by survey will be several years and it does raise the question of the ability of the central bank to accurately forecast that far out.  For various and obvious reasons, the private sector can duplicate the Fed's models and the information set that Fed economists have is not much different than what investors have.  

Their ability to forecast the trajectory of the economy seems no better (and no worse) than the private sector and that is not particularly good for much beyond a year.  Many participants have come to view longer dated forecasts not so much as forecast but policy objectives (which are assumed to be achieved over the longer term).  

There are two things that the Fed is unlikely to do.  First, despite some speculation to the contrary, the Fed is unlikely to set a formal inflation target.  If for no other reason, the Fed seems to prefer doing one thing at a time.  Second, the Fed is unlikely to rule out another round of asset purchases (unilaterally disarm), but we do not expect any encouragement of such expectations outside of an affirmation that it stands ready to do what is necessary.  

Other central banks, including New Zealand, Czech Republic, Norway and Sweden publish the anticipated trajectory of policy rates.  Some studies have found that investors do not place much emphasis on them.  The Fed's publication of the timing and pace of hikes will have immediate novelty value, but over time, the Fed's forecasts will simply be another input to market expectations.   

Bernanke is improving the Fed's transparency without reducing much uncertainty.  The information set that investors have is unlikely to change very much.  The new information is likely to confirm what the market already suspects.  Within a wide range of views at the Federal Reserve, monetary policy is unlikely to be tightened any time soon.