ByKevin L. Kliesen
The Federal Open Market Committee (FOMC) made several changes in late 2007 to improve the clarity of its actions. The committee is seeking greater transparency in what it does, both to improve its accountability and to help the public better understand monetary policymaking.
These changes included: increasing the frequency of the economic projections of the FOMC participants (governors and Reserve bank presidents) to four times per year from two; extending the maximum economic projection horizon to three years from two years; and quantifying, to the extent possible, the degree of uncertainty policymakers attach to their economic projections.
In his remarks describing these changes, Fed Chairman Ben Bernanke said that increased transparency benefits society and the economy in two important ways. First, "Good communications are a prerequisite if central banks are to maintain the democratic legitimacy and independence that are essential to sound monetary policymaking." Second, "Central bank transparency increases the effectiveness of monetary policy and enhances economic and financial performance."
When making important choices, such as how much to save or how much to spend, households and firms have some expectation of how the economy will perform over, say, the next year or two. But they also rely importantly on current and expected future actions by the central bank. Thus, Fed policymakers can help to reduce one layer of uncertainty facing firms and households by providing them with some direction about the current stance of monetary policy and its implications for future economic outcomes.
The degree of transparency practiced by the world's central banks varies considerably. For example, the European Central Bank (ECB) has one of the most transparent policies, characterized by the ECB president's press conference held after each policy meeting. While much less transparent than the ECB's practice, the FOMC's decision to release quarterly economic projections is nonetheless a key innovation in helping the private sector form judgments about the FOMC's future actions. For example, when the new economic projections were released Nov. 20, 2007, they indicated that FOMC policymakers had become modestly less optimistic about real GDP growth in 2008 compared with three months earlier.
In view of the recent turbulence associated with developments in the housing and mortgage finance sector, the market's focus on the Fed's changing view of the near-term outlook is consistent with the FOMC's strategy that attempts to discern the degree of risk to economic growth and price stability. If, for example, the risk of weaker economic growth exceeds the risk of higher inflation, former Fed Chairman Alan Greenspan explains that "the appropriate policy gives more weight to a very damaging outcome [weaker economic growth] that has a low probability than to a less damaging outcome [higher inflation] with a greater probability."
Another key innovation was the decision to extend the projection horizon to three years. Previously, the maximum forecast horizon was slightly less than two years. The extension is a potentially very important development in the monetary policy communication process. For one thing, it reinforces the fact that monetary policy is the main determinant of inflation over longer horizons. It also reinforces the fact that, over time, the overall inflation rate-which households and firms care most about-should be no different from the core inflation rate (minus food and energy), which the FOMC uses as a measure of the underlying inflation rate.
Some economic analysts appear to have interpreted the mid-point of the 2010 central tendency (1.6 percent to 1.9 percent) as the FOMC's long-term inflation preference. However, attaining this outcome may be made more difficult because 1) the composition of the FOMC may change over time and 2) each member, when forming a projection, may have a different view of what an "appropriate" policy stance is.