The Fed's new communication strategy: is it stealth inflation targeting? Or is it simply enhanced transparency?

Business Economics, July, 2008 by Michael Woodford

Along with the minutes of the October 30-31, 2007, meeting, the Federal Open Market Committee released a summary of its members' forecasts of key economic variables, a practice that is to be continued. Does this change in communication policy imply that the Fed is embarking on an undeclared policy of inflation targeting? Recent speeches by members of the FOMC indicate that the objective of releasing the forecasts is to enhance communication of policy concerns relating to its dual mandate of low inflation and low unemployment rather than set a specific target for inflation. This paper discusses the effectiveness of releasing forecasts in communicating the FOMC's policy to the public and its value as an internal discipline. It also proposes ways to include projections of policy interest rates in the forecasts while retaining flexibility to react to changing circumstances.

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Perhaps the most interesting development of 2007 in central-bank communications policy has been at the Federal Reserve. Along with the minutes of its October 30-31 meeting, the Federal Open Market Committee (FOMC) released a summary of the members' forecasts for several economic variables, the first example of information that is now to be released four times a year, following the 1st, 3rd, 4th, and 7th FOMC meetings of each year. The change in communication policy, announced in a press release by the FOMC on November 14, and explained in further detail in a speech by Chairman Bernanke to the Cato Institute's Annual Monetary Conference the same day, represented the outcome of a year-long process of deliberation within the FOMC about ways in which the transparency of Fed policymaking might be improved (Bernanke, 2007).

1. Is It "Forecast Targeting?"

An obvious question about the new policy is the extent to which it represents an attempt to implement for the United States the kind of "forecast targeting" that has been used by a number of central banks with official inflation targets, such as the Bank of England and Sweden's Riks-bank, for the past 15 years. Both Chairman Bernanke and Governor Frederic Mishkin were well known as leading American fans of inflation targeting before taking their current positions at the Fed, and many have wondered whether the Bernanke Fed might adopt some form of inflation targeting. (1) Regular publication of quantiative projections of the future evolution of inflation and other variables--in the Inflation Reports of the Bank of England, that appear four times per year, or the Monetary Policy Reports of the Riks-bank, published three times per year--is a characteristic feature of those banks' approach to monetary policy. To what extent does the Fed's new "enhanced communication strategy" achieve a similar end? Should it be viewed as "stealth" inflation targeting--inflation targeting in everything but the name?

It is useful first to recall the point of the publication of forecasts by the other central banks. "Forecast targeting" is a particular kind of decision procedure for monetary policy, under which the policy committee seeks, each time that it meets, to determine the level of its policy rate consistent with a projected evolution of the economy that would satisfy a quantitative target criterion. For example, the Bank of England often explains its policy as aiming to ensure that the projected rate of CPI inflation at a horizon eight quarters in the future should equal 2.0 percent. Given a criterion of this kind, one that refers to the future conditions that policy is intended to bring about, the bank's internal forecasts play a crucial role in policy deliberations.

The regular publication of the bank's forecasts also plays a central role in these banks' communication policies. The point of publishing the forecasts is to make the nature of the banks' policy commitments evident to the public--and to increase the credibility of these commitments--by allowing the public to observe how policy decisions are actually shaped by the banks' efforts to ensure the fulfillment of the target criterion. The Inflation Reports or Monetary Policy Reports include not only forecasts and discussion of the reasoning behind them, but also, crucially, an explanation of how the bank's most recent policy decisions are justified by the projections presented in the report. The argument presented, essentially, is that

* projections are displayed conditional on a particular assumption about policy;

* the projections can be seen to have the desired properties;

* hence, it may be verified that the assumed policy is an appropriate one.

The commitment to justify policy to the public in this way increases public understanding of the policy and should thus improve the public's ability to correctly anticipate the future conduct of policy, increasing its effectiveness. (2) It also serves the goal of making the central bank more accountable, which provides democratic legitimacy for the central bank's grant of operational independence. (3) Finally, it can improve policy itself by providing a check on possible temptations to base policy purely on short-run considerations and thus lose sight of whether policy remains consistent with the bank's medium-run objectives. (4)