Fed’s Communications Should Reflect an Uncertain World: View

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The U.S. Federal Reserve is planning to the way it communicates with the public. The aim, as we understand it, is to explain better what the central bank is trying to do when, say, it prints hundreds of billions of dollars in hopes of moving interest rates a few tenths of a percentage point.

This is an excellent idea, as long as the practice doesn’t inadvertently give investors a false sense of security.

At today’s meeting of the Fed’s open market committee, officials will iron out details of the new communications strategy, which is likely to be released early next year. Some of the expected innovations include clearer statements of the Fed’s inflation and employment goals, and more information in quarterly economic forecasts on how it expects to reach those objectives. Innocuous as the changes may seem, they’re a big deal for a central bank that, until 1994, didn’t publicly announce its interest-rate decisions.

The greater transparency has a number of advantages. For one, it could help eliminate the kind of market volatility that arises when investors aren’t sure how the Fed will react to economic developments, such as an increase in oil prices or a drop in employment. By clarifying its reaction function, the Fed can avoid becoming a source of instability in itself.

In the current environment, better communication can also make the Fed’s monetary-policy moves more effective. Consider, for example, the uncertainty last year over whether the central bank would follow through on its plan to reduce long-term interest rates by buying some $600 billion in bonds. If the Fed had committed in advance to completing the purchases as long as the unemployment rate remained above a certain level, it could have avoided the confusion that many believe blunted the impact of the quantitative-easing program.

Dangerous Certainty

Attempts to provide certainty, though, can be dangerous. If, for example, investors come to expect that the Fed will always rescue them in times of trouble, they will be more likely to take on the kinds of risks that invite disaster. During the housing boom, many investors assumed the Fed would act to prevent a sharp drop in home prices -- a belief that encouraged them to set the economy up for a bust.

Here, the Fed might want to take a page from the playbook of the Bank of England, which has long produced a detailed quarterly report on its forecast for inflation and the economy. The report contains a section called “key judgements and risks,” in which the bank clearly states the assumptions on which its outlook is built, and how they may be wrong. Ideally, the Fed could use such truth-telling to make sure investor expectations don’t get out of hand.

We’re all for more communication. It’ll be even better if what’s being communicated isn’t hubris.

To contact the senior editor responsible for Bloomberg View’s editorials: David Shipley at davidshipley@bloomberg.net.