The Fed's Confusion over Interest Rates

Published in El Pais

October 18, 2015

Ben Bernanke, in his recently published memoirs, says that monetary policy is 98 percent communication and 2 percent action. During his tenure as a central banker he scrupulously followed this principle. Shortly after being named governor of the Federal Reserve in 2003, he gave a speech stating that the success of monetary policy depends mostly on the central bank's ability to communicate its plans and objectives. During his tenure as Fed chairman he insisted on increasing transparency, describing the mechanism used to adopt policy decisions (the "reaction function" of monetary policy), promoting the adoption of an inflation target (2 percent) and increasing the amount of information explaining Fed decisions. This included post-meeting press conferences and the famous "dot plot" chart, which the members of the Federal Open Market Committee produce to describe the likely path of interest rates that each member expects.

Unfortunately, in recent months the Fed has created tremendous confusion with its communication policy, losing much of the credibility it had gained. An accumulation of execution errors, not a change in strategy, is beginning to take its toll. Markets are paying increasingly less attention to Fed statements and warnings, and the gap between market pricing and the Fed's public guidance on interest rates is increasing. The more this disagreement continues, the harder it will be to solve it without pain.

In recent months the Fed has created tremendous confusion with its communication policy, losing much of the credibility it had gained.

The reasons for this divergence are many. On the one hand, there is the eternal debate about how monetary policy affects financial stability. While financial stability is not in the explicit mandate of most central banks, it is used as a wildcard by those who want to raise rates without any other valid argument to justify it. Despite the steady decline in inflation, the Bank for International Settlements has relentlessly advocated interest rate hikes, arguing that financial stability risks are increasing after years of zero interest rates. The hawks at the Fed and at other central banks use similar arguments, but nobody has been able to articulate in detail how to use interest rates to deal with financial stability, nor show convincing evidence that zero rates have a special impact on financial stability. There are no clearly identifiable financial bubbles, credit growth remains weak, and banking and financial regulation is becoming more restrictive.

On the other hand, there is the dual nature of the Fed's mandate: price stability and maximum employment. This duality served the Fed well during the crisis, as it supported a very expansionary monetary policy despite inflation slowing less than one could have imagined, given the size of the recession. But now this duality is pushing the Fed into the hawkish side: Some argue that labor market models show the United States is very close to full employment, and therefore it is becoming urgent to start raising rates to avoid an undesirable acceleration in inflation. The problem is that this argument has been made for over a year, and neither prices nor wages have moved higher. It is very possible that labor market models are unable to capture the structural changes that are compressing inflation. In fact, Fed Governor Lael Brainard said last week that the labor market situation is not a sufficient statistic to determine the inflation outlook. The labor market data should be seen as just an intermediate target towards the medium-term price stability objective, not an objective in itself.

Since September 2008, core inflation has been below the Fed target for 95 percent of the time, which partly explains why inflation expectations have declined. With this in mind, it is strange that the Fed resists adopting a more expansionary policy stance that generates a period of above target inflation to compensate for this long period of below target inflation. Despite claiming that its inflation target is 2 percent, the Fed is acting as if its target is close to, but below, 2 percent. At present, it would appear that the European Central Bank has moved to Foggy Bottom and occupied the intellectual space of the Fed.

The Fed insists it wants to raise rates before the end of the year, but markets insist in not believing it, because if one uses the reaction function the Fed has always communicated there is no reason to do it. The markets have followed Bernanke's teachings and learned the Fed's reaction function over the years, and have concluded that, in view of the economic outlook, interest rates should not be raised until mid-2016.

If the Fed has changed its reaction function, it should explain it and openly acknowledge that there are factors beyond the inflation outlook that are affecting its decision making. Transparency is critical. If the Fed is not able to explain convincingly why it wants to start raising rates, the risk of failure will be high. The world economy is in transition and developed economies have to replace emerging markets as a source of stability. The Fed is caught in its own inertia, as it has spent many months preparing the ground for a rate hike in the second half of this year. But the reality is that if one ignores the inertia, there is no good reason to raise rates this year. And, with rates at zero, there is little room to correct mistakes. The Fed is confused, and the cost of this confusion could be very high.