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

Business Economics, July, 2008 by Michael Woodford

A good example is the situation faced by the Fed in the summer of 2003 (Woodford, 2005). The funds rate operating target had been reduced to only one percent and could surely be reduced little further, if at all. Market speculation consequently focused on how soon and how sharply rates would be raised again. Indeed, speculation that the Fed would raise rates substantially within a matter of months was already causing long-term interest rates to rise, creating a situation that, it was feared, could actually tip the U.S. economy into deflation. The FOMC could not, or at any rate was certainly reluctant, to counter these expectations through any further cut in the current operating target. But instead, it was able to calm market fears of an early tightening of rates by explicitly committing to maintain low rates "for a considerable period," beginning with the statement following its August meeting. Somewhat similar considerations had led the Bank of Japan more than two years earlier to commit itself explicitly to maintain its zero-interest-rate policy until deflation had clearly ended. Also, in that case the policy signaling facilitated the achievement of policy objectives by helping to keep long-term interest rates low. (6)

While explicit discussion of the level of interest rates that is expected to be chosen at future meetings can be useful on occasions like those just mentioned, it is clearly not possible under all circumstances to expect that interest rate decisions will be signaled many months in advance. The events of the fall of 2007, when central banks had to keep abreast of rapidly changing market conditions and, at the same time, needed to be free to announce policy changes precisely to respond to perceived changes in market expectations, have, for obvious reasons, made central banks reluctant to announce in advance what they might or might not wish to do even a few weeks later.

7. Could the United States Learn from the Smaller Central Banks?

Does this mean that there is no useful way for central banks to communicate about future policy? Here, as in other respects, I think that banks like the Fed have much to learn from the communications policies of the forecast-targeting central banks. Banks like the Reserve Bank of New Zealand (for the past decade), and more recently the central banks of Norway and Sweden, include quantitative projections for the future path of the policy rate along with the projections for inflation and real activity that are discussed in their Monetary Policy Reports. These quantitative projections have a number of advantages over the use of "code words" as practiced by banks like the Fed, the ECB, or the BOJ. One is the simple fact that they are much less ambiguous. But another is that they clearly represent forecasts, conditional on what is known at the time, rather than advance commitments of policy, In contrast, the code words have frequently been understood as announcements of policy intentions, and have had to be kept ambiguous precisely to reduce the extent to which future policy decisions can be regarded as having already been announced. An interest rate fan chart, of the kind published by the Norges Bank or the Riksbank, does not suggest policy commitment. It is published alongside similar fan charts for other variables, which clearly represent forecasts rather than promised outcomes. Moreover, these are not single paths; the widening of the probability distributions with the forecast length makes it clear that no specific outcome is being promised in advance.