Jan 26 2012
I haven’t the slightest idea what will happen if Ben Bernanke sees his shadow on February 2. However, the Federal Reserve Chairman did shed some additional light on the future of monetary policy on January 25.
At their two-day meeting, the Federal Open Market Committee (FOMC) decided to leave the fed funds rate at 0 – ¼ percent. More surprisingly, they’re likely to keep it at “exceptionally low levels” until at least late 2014. This is a year and a half longer than previously announced. It is either good or bad news depending on whether you pay or receive interest!
FYI: the fed funds rate is what banks charge each other for short-term loans. The Fed is able to raise and lower this rate by adjusting the amount of reserves in the banking system. In so doing, it affects virtually all short-term interest rates.
For years, the Fed has been publishing its forecasts for GDP, inflation and the unemployment rate. These attracted relatively little attention. However, on January 25 the FOMC revealed the interest rate projections of individual members (without naming them) for the next several years and the longer run. While there’s quite a range, the majority saw fed funds still below 1% by 2014.
I found the much narrower range for the longer run fed funds forecast of 4 – 4 ¼ percent quite interesting. This is what the Fed expects would prevail when the economy is back to normal: unemployment around 5 ½ percent, real GDP growing about 2 ½ percent and inflation at 2 percent. While the yearly forecasts don’t go beyond 2014, I would guess this is somewhere around 2016-17.
So what’s the big deal? Before 1994, the FOMC didn’t even announce its decisions and gave no clues as to what might happen in the future. They would simply adjourn and go home, leaving financial markets to figure out what had happened. Most times they got it right, but I remember one time in the late 1980s when a large bank mistakenly thought the Fed had increased the fed funds rate. Accordingly, they raised their prime rate, but nobody else followed so they rather sheepishly had to rescind the increase a few days later.
Over the past two decades, the Fed has become increasingly transparent. By 2000 it was releasing a statement at the conclusion of the meeting which gave the decision as well as a few tidbits that might give some clues to future decisions
Bernanke is a firm believer in the power of communications or what Teddy Roosevelt called the “bully pulpit.” Contrast this with Alan Greenspan, who simply loved to obfuscate and only reluctantly released information about the Fed. He once quipped, “If you understood what I said, then I must have misspoke.”
Bernanke believes that there is nothing to be gained in having financial markets gyrate as they try to figure out what the Fed will do next. If rates are likely to stay flat, that’s important information. If they have to rise, then markets should be able to prepare for that eventuality.