By Steven K. Beckner
(MNI) – As Federal Reserve policymakers work to perfect their
communications strategy one word keeps coming to the fore: credibility.
Clarifying the Fed’s intentions through more transparent
communications is not an end in itself, although Fed Chairman Ben
Bernanke has often extolled the need for “accountability.” Communication
is regarded as a policy tool in its own right.
Credibility — essentially public belief that the central bank
means what it says and is capable of achieving what it sets out to do —
has always entailed the believability of the Fed’s commitment to “price
stability.” Now, it is taking on new meanings as the Fed seeks to
convince everyone it will keep interest rates very low longer than it
Credibility is really what monetary policy is all about. Indeed,
it’s what central banking is all about in an era of fiat money. In a
monetary system where the currency is no longer backed by or
convertible into precious metals, credibility or confidence in the
central bank’s ability and willingness to preserve the value of the
currency becomes a precious commodity.
Indeed, one author has called central banking “The Confidence
When people lose confidence in their nation’s currency, which is
another way of saying the central bank loses its credibility, the jig is
up as far as controlling inflation, as various nations have discovered.
The supreme measure of this credibility is thought to be inflation
expectations, which is why Bernanke and his colleagues regularly
maintain that long-term inflation expectations are “well-anchored,” even
when “break-even” spreads between Treasury’s conventional and inflation
protected securities (TIPS) fluctuate considerably.
Even the most “dovish” Fed officials talk about the value of low
inflation expectations. It might even be said they especially value this
form of credibility because, in their minds, it gives the Fed latitude
to provide more monetary stimulus.
That theme was contained in a January statement of Longer Run Goals
and Policy Strategy, in which the Fed’s policymaking Federal Open Market
Committee first put forth its 2% “inflation goal.”
“Communicating this inflation goal clearly to the public helps keep
longer-term inflation expectations firmly anchored, thereby fostering
price stability and moderate long-term interest rates and enhancing the
Committee’s ability to promote maximum employment in the face of
significant economic disturbances,” the FOMC said.
A few months later, Bernanke said, “the concern we have is that if
inflation were to run well above 2% for a protracted period, … the
credibility, and the well anchored inflation expectations, which are
such a valuable asset of the Federal Reserve, might become eroded, in
which case, we would in fact have less rather than more flexibility to
use accommodative monitoring policy to achieve our employment goals.”
Or, as Fed Vice Chairman Janet Yellen observed in June, “the fact
that longer-term inflation expectations have not risen above 2% has also
proved extremely valuable, for it has freed the FOMC to take strong
actions to support the economic recovery without greatly worrying that
higher energy and commodity prices would become ingrained in inflation
and inflation expectations, as they did in the 1970s.”
But various Fed “hawks” have argued that, as the Fed pursues its
third round of large-scale asset purchases or “quantitative easing,” it
is stretching the limits of its credibility.
In a September interview with MNI, Philadelphia Fed President
Charles Plosser asked, “How long will we keep doubling down (on
quantitative easing?” Continuing to pump more and more money into the
economy risks the Fed’s credibility both as an inflation fighter and as
a growth promoter, he contended.
Inflation aside, Plosser said “conveying something about the power
of monetary policy that we don’t have undermines our credibility.”
Richmond Fed President Jeffrey Lacker also expressed concern about
an erosion of the Fed’s anti-inflation credibility in a late October
interview with MNI.
Pointing to a rise in TIPS spreads, Lacker said, “I don’t think
it’s broken out yet,” but “it does seem to represent … a perception on
the part of financial market participants that our commitment to price
stability may have diminished, and that’s worrisome to me.”
For now, anyway, the Fed has the luxury of being able to draw on
the stores of credibility built up through three decades of relative
price stability since Fed Chairman Paul Volcker launched his campaign to
defeat double digit inflation in October 1979.
But the Fed is also exploring new avenues of credibility and,
in the process, developing new “communication tools.”
Lately, confident that its anti-inflationary credibility is intact,
the FOMC has been reaching for a new kind of credibility. It is striving
to increase public belief in its quasi-committment to hold the federal
funds rate near zero for another three years or so in pursuit of faster
economic growth and lower unemployment.
The FOMC’s newest communications strategem — first adopted on Sept.
13 and reaffirmed on Oct. 24 — is a pledge to keep monetary policy
“highly accommodative” for “a considerable time after the economic
That language in the FOMC statement supplemented the Committee’s
updated “forward guidance” on the path of the funds rate. Since
September, the FOMC has said it expects to keep the federal funds rate
near zero “at least through mid-2015.”
In yet another communications innovation, the FOMC made “QE3″
open-ended and said it expects to keep buying $40 billion per month of
mortgage backed securities — and possibly more — until it sees
“substantial” labor market improvement.
Some officials see these rhetorical departures as another threat to
the Fed’s credibility as the guarantor of price stability. “The signal
sent by that (‘considerable time’) phrase … could be misconstrued as a
willingness to tolerate higher inflation,” Lacker told MNI.
But for the FOMC majority, the assertion that it expects to
maintain “exceptionally low” interest rates and a large balance sheet
even after the economy picks up steam is needed to reinforce another
kind of credibility. The FOMC wants to convince markets and the public
it really means business when it projects a continuation of zero rates.
The Sept. 13 language changes came sharply on the heels of the
Kansas City Fed’s annual Jackson Hole symposium in late August, a
highlight of which was Columbia University Professor Michael Woodford’s
biting critique of Fed communications strategy.
Woodford argued that, by saying it will keep the funds rate at
zero for another three years or so (on top of the nearly four years it
has already been at zero), the Fed might be sending exactly the wrong
signal – a counter-productive signal that the economy is in for even
more problems than previously thought and that therefore people will
want to save even more, rather than spend.
Woodford contended that merely extending the period of zero rates
does little good unless the market and the public can be convinced the
FOMC will not change its mind and “prematurely” raise rates when
economic growth accelerates and unemployment declines.
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