The Fed's Next Communication Challenge: Less Is More?

NEW YORK (TheStreet) -- Central bankers have fallen in love with words. With benchmark rates in much of the developed world near zero, eliminating the traditional source of monetary stimulus, policy makers turned to talk to telegraph their intentions. The idea was that assurances of a continued low short-term interest rate would reduce medium- and long-term rates and encourage economic growth.

The Federal Reserve considers market expectations such a crucial element of its strategy that it elevated "forward guidance" to a policy tool. What happens when the Fed has to change course? Will their crystal balls get a bit cloudy? We may be seeing hints of that already.

Fed Chairman Janet Yellen used her April 16 speech to the Economic Club of New York to recap the "evolution of the Fed's communication strategy." And evolve it has, at a record pace (compared to the eight decades it took for the Fed to begin announcing its policy changes). As recently as 2010, the Fed's forward guidance consisted of an indefinite pledge to hold the funds rate near zero "for some time" or "for an extended period." In 2011, the Fed switched to calendar-based guidance ("until mid-2013" or "until mid-2015"). Then came quantitative thresholds in December 2012 ("at least as long as the unemployment rate remains above 6.5%"). And in March, with the unemployment rate closing in on that threshold, the Fed reverted to qualitative (read: fuzzy) guidance. Policy makers will now consider "a wide range of information," including indicators of the labor market, inflation and financial conditions, in setting policy.

Now that's informative! They might as well state their dual mandate -- maximum employment and 2% inflation -- and leave it at that.

The Fed reiterated its qualitative guidance at the conclusion of its meeting Wednesday and announced another $10 billion reduction in monthly asset purchases to $45 billion.

The return to qualitative guidance suggests the Fed is starting to realize the implications of speaking too clearly in a rising interest-rate environment. In the same way that financial markets priced the Fed's highly accommodative policy into the future, those same markets will adjust immediately once the Fed lays out a trajectory for restoring the funds rate to a more normal level. The Fed views the neutral funds rate -- the rate that will keep the economy growing at its potential in perpetuity -- at 4%.

Were the Fed to suggest such a trajectory, even over "an extended period," traders and investors would see no reason to buy a 10-year Treasury note yielding 2.66%. As yields rose, the Fed would caution markets not to get ahead of themselves for fear that higher long-term rates could derail the expansion. Under the circumstances, forward guidance might lose some of its appeal, not to mention benefits.

The real problem with forward guidance has nothing to do with the business cycle. Simply put, the future is always uncertain. At best, forward guidance is an educated guess.

Enter Stanley Fischer, former governor of the Bank of Israel and and one-time MIT economics professor to the stars, including Larry Summers, Ben Bernanke and Mario Draghi. On Tuesday, the Senate Banking Committee unanimously approved Fischer's nomination to be Fed vice chairman. Fischer is on record saying that the Fed would do better not to telegraph future policy decisions. Why? Because it doesn't know what it's going to do.

Bingo! Someone who tells it like it is. Pending confirmation by the full Senate, Fischer, along with fellow nominees Lael Brainard and Jerome Powell, a sitting governor, could be in place for the mid-June meeting. Knowing Fischer's views on the dubious value of forward guidance, it will be hard to discern whether any future devaluation of communication is the result of his influence or the realization that when it comes to telegraphing higher interest rates, the less said the better.

This article represents the opinion of a contributor and not necessarily that of TheStreet or its editorial staff.

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