The Fed’s Double Gates

Secrecy cuts two ways. It can make central bankers seem more all-knowing and increase their short-term flexibility, but it can also confuse the public, wrong-foot markets, and fuel conspiracy theories. And, in a world of greater transparency and accountability throughout the public and private sectors, secretive policymaking at the Fed was beginning to feel anachronistic. I also believed that, on net, secrecy reduced the effectiveness of monetary policy. As Rick Mishkin and I had argued in our work on inflation targeting, monetary policy works better when the central bank communicates clearly with markets and the public.

Ben S. Bernanke, “The Courage To Act”.

To provide clarity, what if the Fed paints this picture to the public:

The goal is to pass through two gates to come to a decision. The first gate is called the “Gate of Feedback Loop”. This gate is conditional on the exchange rates, imports and exports, China, anchoring of future inflation expectations, asset bubbles, market fragility, etc. The first gate is the “can we or can’t we do it” gate – a binary decision.

Having passed gate one, we come to gate two, which is called the “Gate of Credibility”. This gate is data dependent, and based on a set rule that although announced in general to the public, is kept confidential in specificity. For example, it could be a series of if then statements that goes like this:

If w1x1 + w2x2 + w3x3 + … + wnxn < 0, then lower rates

If w1x1 + w2x2 + w3x3 + … + wnxn = 0, then maintain rates

If w1x1 + w2x2 + w3x3 + … + wnxn > 0, then increase rates

w being the predetermined weights to reflect the priority and importance. x being the delta of factors under consideration, such as unemployment, wage growth, consumer spending, market volatility, potential GDP, etc.

It is not important for the public to know the weightings, neither is it desirable. It is enough that the public knows it is not a random decision.

To maintain credibility, the Fed has to confirm that it does indeed have a target, and yet in trying to achieve this, it must consider external factors as well – just like an archer estimating the distance of the bullseye, who must also consider the direction of the wind to be accurate in the trajectory of his arrow.

“Systematic and predictable manner”, as Macro and Other Market Musings writes,

Now to be clear, the point of this post is not that the Fed failed to correctly forecast the future economy. Rather, it is that the Fed failed to clearly spell out how it would systematically respond to differing states of the future economy. For the Fed to truly manage expectations (and therefore fully exploit its influence over economic activity) the public should know with some certainty how the Fed will respond to different economic developments. Over the past five years this certainty has been largely lacking. (The only thing that does seem certain over this period is that Fed wanted core inflation to fall somewhere between 1 and 2 percent. And even this understanding only became apparent in hindsight.) Now imagine the Fed’s monetary stimulus programs during this time had be done in a more systematic and predictable manner.

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