January 23, 2012

Fed’s Transparency Policy Meets Skepticism on Wall Street

Economist Ezrati warns new approach could cause more harm and disruption than the former secrecy did

The Federal Reserve launches its new transparency initiative this week, but a prominent economist is warning the move could “greatly increase the risk of severe market and economic disruptions.”

In a recent market commentary, Lord Abbett senior economist and market strategist Milton Ezrati discusses the Fed’s new strategy to publish the predictions of its senior officials as a means of increasing the impact of its policies.

The Fed’s first forecast about the level of short-term interest rates and how long Fed officials think they should be kept there is set for Wednesday, after the conclusion of a two-day policy meeting. While the Fed hopes to magnify the impact of its policies by convincing investors the Fed is committed to an accommodating stance on interest rates for a long time, thereby further driving down consumer borrowing costs, Ezrati argues the new communications strategy has the potential to backfire.

“The crux of the problem lies in the very real possibility that the Fed will find it impossible to stick to its stated interest rate expectations,” Ezrati (left) writes. Since midcourse corrections are a predictable part of monetary policy decision making, the Lord Abbett economist worries that investors–relying on Fed rate predictions as immutable–will all react in the same way when surprise policy reversals occur, “leading to much more severe economic and financial disruptions than would otherwise have occurred.”

In contrast, the secrecy that has been policy until now had investors and business people guessing about the direction of interest rates, meaning that investors making opposite predictions moderated the impact of policy adjustments on the economy.

If the Fed seeks to forestall the possibility of such disruptions, it could advise investors to treat its rate predictions with caution, Ezrati says. But in so doing, the Fed would “make them reluctant to plan as definitely and as boldly as the Fed recently said it wants,” he writes. “This decision for transparency, then, seems poised either to defeat its own purpose or invite dangerous misunderstandings,” Ezrati concludes.

The Fed’s new communications policy is generating skeptical reviews among other economists as well. Reuters quotes Morgan Stanley’s chief U.S. economist Vincent Reinhart as saying the policy “may amount to little more than a strong commitment to motherhood and apple pie among central bankers–i.e., the importance of price stability in the long run–but provide no practical guidance as to near-term policy choices.”

Reprints Discuss this story
This is where the comments go.