Why a Little Fed Transparency Could Be Dangerous

For decades, investors have spent countless hours speculating about the Federal Reserve's agenda on interest rates. Market watchers study every adjective in often-cryptic Fed statements for clues about the outlook for monetary policy. Even the smallest nuances can lead to big swings in global markets.

But the Fed hopes to make this signal decoding less difficult starting next week, when it will lift the shroud of secrecy and release the interest rate projections of the members of the Federal Open Market Committee (FOMC).

This move toward greater transparency has generated a flood of speculation about the potential effects on the economy and financial markets. Some observers have suggested that the new information could stimulate the economy by lowering interest rates. Others fear that the Fed's efforts might increase market volatility and harm its own reputation if the forecasts are revised too often or if they reveal too much internal disagreement.

Supporters and skeptics alike would agree this is an historic moment for the Fed, and anticipation is running high for the inaugural release of the forecasts of the federal funds rate, the interest rate the Fed controls directly. However, a look at the details of the Fed's intentions suggests that the roll-out next week could be a complete dud, and perhaps even a significant communications error.

In this case, a little transparency is a dangerous thing, because the Fed plans to take a full three weeks to release all the information. Like removing a band-aid in slow motion, this could cause markets to wince. The Fed can avoid this pitfall by making more of the forecast information available immediately.

The three-week period is a legacy of the procedure now in place for publishing its forecasts for economic growth, the unemployment rate, and inflation. On the day of the FOMC meeting, the Fed provides a highly aggregated synopsis of these forecasts. This summary reveals only the lowest and highest forecasts submitted by the 17 FOMC members and the "central tendency" range that strips out the three lowest and the three highest forecasts to capture the views of the core of the Committee. Chairman Ben Bernanke uses this summary for his press conference after the FOMC meeting. Three weeks later, the Fed publishes the full report on the forecasts.

In the past, the distinction between the initial release of summary information and the full report has not been a major issue. That's because the Committee's forecasts have tended to be similar enough that the summary pretty much told the whole story. However, that is not likely to be true for the interest rate forecasts.

The reason is that the Reserve Bank presidents, who all submit forecasts, have very different views about the appropriate path for monetary policy. Four of the twelve presidents (Charles Plosser of Philadelphia, Richard Fisher of Dallas, Narayana Kocherlakota of Minneapolis, and Jeffrey Lacker of Richmond) are policy hawks. All except President Lacker were voting members of the FOMC in 2011 and those three dissented from the August decision to keep the funds rate exceptionally low through at least mid-2013. The recent speeches of these four presidents suggest no change of heart regarding policy.

At the other end of the spectrum, four presidents have been outspoken in expressing dovish views (Eric Rosengren of Boston, William Dudley of New York, Charles Evans of Chicago, and John Williams of San Francisco); a fifth president (Sandra Pianalto of Cleveland), though less visible nationally, has also expressed deep concerns about the unemployment situation. The full range of forecasts for the target funds rate will be very wide. Even more problematic, the central tendency - which market participants generally focus on - will not clarify matters, because trimming the bottom three and top three forecasts will leave in one hawk and at least one dove.

Much of this uncertainty will probably be resolved three weeks later with the publication of the full report. Informed observers will be able to identify the true weight of opinion on the FOMC by studying the entire distribution of responses. But this will be small consolation for market participants who will have to puzzle over the Fed's initially unhelpful release of the interest rate forecasts. This drawn-out process will not be conducive to calming volatile markets, enhancing the Fed's reputation, or reducing interest rates.

These problems can be avoided by releasing more-complete information about the interest rate forecasts immediately after the January 24-25 FOMC meeting. That way, one would know, for example, how many Committee members expect the funds rate to remain at the current level of 0 to 1/4 percent at the end of each year, how many expect it to be between 1/4 and 1/2 percent, and so on. There is no reason to sit on this information for three weeks.

Perhaps the Fed is working behind the scenes to produce a more helpful forecast summary. If not, one hopes there is still time to change course and avoid a potentially serious self-inflicted wound next week.