- The Washington Times - Monday, December 11, 2006

Economic research has traditionally played a key role in guiding Federal Reserve policy decisions. Sometimes a whiff of possible policy changes can be found among the voluminous outpourings of Fed research.

One of Federal Reserve Chairman Ben Bernanke’s special areas of interest is Fed transparency. He is a passionate believer in openness, and last spring, shortly after becoming chairman, appointed a committee to help the policymaking Federal Open Market Committee (FOMC) find ways to improve the transparency of its decisionmaking.

At one time, Fed secrecy was considered a virtue and openness was thought detrimental to the economy. That view changed, and in the last decade many central bank mysteries have been revealed. Among the revelations have been the economic forecasts, albeit limited, of the FOMC. In its semiannual Monetary Policy Report to the Congress the Fed now includes the committee’s forecasts of economic growth, core inflation, and the unemployment rate for the current and forthcoming year.

Mr. Bernanke favors Fed adoption of inflation targeting, i.e., publicly announcing a specific medium- or long-term numerical inflation target. Proponents believe targeting would better inform markets, help anchor inflation expectations, and promote stable economic growth and low inflation. Opponents (including former Fed Chairman Alan Greenspan) say targeting is mechanical and would limit Fed flexibility to respond to unexpected events. Some also fear markets might overreact to the announced targets, undermining economic stability.

Mr. Bernanke has said the Fed will not adopt inflation targeting unless the members of the FOMC agree, and for the moment the issue seems to be on hold.

Now another sensitive transparency issue has reared its head. Two economists at the Federal Reserve Bank of San Francisco, Glenn D. Rudebusch and John C. Williams, have recently completed a paper (or dropped a small bombshell), “Revealing the Secrets of the Temple: The Value of Publishing Central Bank Interest Rate Projections.” The authors developed an analytical framework that shows making public the FOMC’s policy interest rate (i.e., federal funds rate) projections “can help shape financial market expectations and may improve macroeconomic performance.”

When markets are unsure about future Fed policy, say the authors, “publishing interest rate projections can help align private and public expectations of future policy actions [and] can have a potentially significant effect on the ability of the public to predict future policy actions.” Better predictions, in turn, result in less fluctuation in output and inflation and lead to improved economic outcomes.

Skeptics have asked whether FOMC members can agree on an interest rate forecast. But doubtless one already exists internally. Should members be unable to agree on a single forecast, a range could be published accompanied by a description of the related macroeconomic variables consistent with the upper- and lower-level estimates. The conditional nature of the forecasts would have to be made clear, with a statement they are subject to change as economic events unfold.

Care would be needed so the public doesn’t interpret the forecasts are promises. It would be a disaster if markets misinterpreted the forecasts and its erroneous expectations were subsequently frustrated by forecast revisions. Fed credibility could be severely damaged.

The case for the FOMC announcing its numerical interest rate forecasts is not only theoretical. As Mr. Rudebusch and Mr. Williams noted, the central banks of New Zealand and Norway already follow such a policy. New Zealand pioneered the practice in 1997, and more recently Norway added sophistication by publishing confidence intervals around alternative future interest-rate scenarios. The evidence is that the policy has worked well in both countries and, according to Mr. Rudebusch and Mr. Williams, “has not led to excessive or counterproductive market reactions.”

So far Mr. Bernanke has not spoken on the record about whether the Fed should publish its interest rate forecasts. However, in an October 2004 speech then-Gov. Bernanke said: “It’s my own view that we are approaching the limit of purely qualitative communication and should consider the inclusion of quantitative information presented in a clearly specified framework. For example, like policymakers at many other central banks, the FOMC could… include explicit economic forecasts, conditioned on alternative assumptions, in its statements or in regular reports.”

Sounds propitious. Stay tuned.

Alfred Tella is former Georgetown University research professor of economics.

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