More Transparency, But Not a Crystal Ball
On January 3, the Fed released the minutes from the December Federal Open Market Committee (FOMC) meeting and revealed that it will begin publishing the Committee’s interest rate projections. The goal of this action is to provide more transparency in the policymaking process. However, there are limitations to the information these types of projections provide. Examining the experiences of some foreign central banks illustrates what conclusions might and might not be drawn from the new data.
FOMC participants included three new pieces of information when they submitted their Summary of Economic Projections for January’s meeting. In addition to projections for real GDP, the unemployment rate, PCE inflation, and core PCE inflation, participants included projections for the target federal funds rate, a projection of the likely timing of the first increase in the target rate, and a narrative explaining their assessment. Each participant’s projections were based on his or her view of the appropriate course of monetary policy.
How these projections would be presented was specified in a press release the week prior to the January meeting. Since participants submitted their interest rate projection for the fourth quarter of each of the next few years, and the longer run, a histogram illustrates the number of participants that expect the initial target federal funds rate increase to occur by the fourth quarter of a given year. In addition, each participant’s projected path of the fed funds rate shows the spectrum of appropriate policy views. Perhaps more importantly, though, the summaries that will be released with January’s meeting minutes will include a narrative describing how committee participants made their assessments. This should, as we will discuss shortly, provide some of the most meaningful information about the participants’ preferences in determining policy.
By publishing interest rate projections, the Fed is continuing its recent trend of increased transparency, as well as following in the footsteps of several other central banks. The Reserve Bank of New Zealand began publishing future interest rates in 1997, and Sweden’s Riksbank and Norway’s Norges Bank followed suit in the mid 2000s. However, it is expected that the FOMC has at least one distinct advantage in providing its projections.
With the other central banks mentioned, the policymaking group (their versions of the FOMC) must come to a consensus on the projected path of policy interest rates. Forming a consensus is a hurdle, and it is one of the main arguments against providing forward guidance on interest rates—and based on the recent dissents within the FOMC for policy decisions, it would seem that forming consensus projections might be difficult. But by asking each participant to provide his or her own projections, this problem is avoided.
A larger concern is that the public will misinterpret the meaning of the projections. For one thing, the projections are not the FOMC’s planned path for interest rates, as the December minutes make clear. But that misinterpretation has already been made in the press and pointed out by Dave Altig of Macroblog.
Also, the interest rate projections are based on current projections of future economic conditions, and as we know too well, the future can be pretty unpredictable. Take, for example, the recent experiences of New Zealand, Sweden, and Norway. Each of these countries’ central banks released projections that turned out to be wide of the mark because the bank’s expectations for future economic conditions were not met. The first and most glaring instance was heading into the recession in the fall of 2008. All three banks made several projections that severely underestimated the decline in economic output that was soon to occur. As a result, in March 2008, New Zealand had projected an official cash rate for March 2009 of nearly 9.0 percent, but the rate was set at 3.0 percent by the time March 2009 arrived. Over the same period, Norway had projected 5.5 percent for its sight deposit rate but instead set a rate of 2.5 percent, and Sweden had projected 4.3 percent for its repo rate but set a rate of 1.5 percent.
Even more recently, all three countries had projected stronger growth rates of GDP following their recessions. As their recoveries wore on, much like in the United States, it became clear that economic growth was slower than expected, and thus interest rates would need to remain lower than projected. By March 2010, New Zealand was projecting an official cash rate of 5.0 percent at the end of 2011, but the rate was actually set at 2.3 percent. Similarly, the target interest rate projections of 3.3 percent and 2.4 percent outdid the actual policy interest rates of 2.0 percent and 1.8 percent in Norway and Sweden, respectively.
The obvious conclusion to be drawn is that these projections do not represent any sort of definitive path of future policy interest rates. These projections are based on the current set of economic conditions and the way central bankers believe economic conditions will evolve in the future. That means that if the state of the global economy does not follow the path that the central bankers expect, they would likely project an altogether different path of policy interest rates. This is already apparent in the structure of the FOMC’s summary of projections, which includes the qualification that the projections presented are the expectations of policymakers “in the absence of further shocks and under appropriate monetary policy.” So, any large-scale event, like a sovereign debt crisis, will alter the expectations of FOMC participants, and in turn the path of their projections.
Still, projections of the federal funds rate should provide a guide as to how the FOMC is thinking about economic conditions and how those conditions influence its policy choices. One might characterize this as a basis for the public to infer a policy reaction function. The idea is that the public could see what the participants expect to happen in the economy, and then based on those expectations, how they would respond in their policy decisions. In some respects, the submitted projections will be a set of hypothetical situations, with each element of the set providing an insight into how the FOMC participant would respond to that situation.
By providing these viewpoints, the goal is to inform the public about how the FOMC thinks about the economy. If the public can better predict how the FOMC will respond to changes in economic conditions, people can better incorporate that information into their economic decisions. In a research paper, the economists Glenn D. Rudebusch and John C. Williams showed that this alignment of public and central bank expectations reduced the magnitude of fluctuations in output and the difference between the inflation rate and its target (“Revealing the Secrets of the Temple: The Value of Publishing Central Bank Interest Rate Projections”).
Other central banks have tried to communicate the conditionality of these projections by producing fan charts, or probability distributions. Below is a chart from the Norges Bank in March 2007. At that time, it predicted that its sight deposit rate would reach 5.0 percent by March 2007 and then level off between 5.5 percent and 5.0 percent until the end of 2010. By the time December 2008 arrived, economic conditions had worsened, so the Norges Bank began lowering its target interest rate. The rate fell below 2.5 percent by March 2009 and eventually settled at 2.0 percent. When the projections were made in March 2008, they were conditional on economic conditions developing according to policymakers’ estimations, but policymakers were also uncertain that their expectations would be met. Thus, they included a probability distribution around their projection, which outlines a range of possible monetary policy responses to unexpected changes in economic conditions.
This example may not be illustrative of what the FOMC has provided because the FOMC’s Summary of Economic Projections comprises a collection of participants’ projections. But based on the practices of other central banks, an observer might expect that each FOMC member is thinking about their projections in a way similar to this fan chart.