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The Fed's open window


Chairman Bernanke's push for transparency carries risks, but the potential benefits are greater.

January 28, 2012
(Win McNamee/Getty Images )

The Federal Reserve's announcement that short-term interest rates are likely to stay low for two years or more drew the usual mix of catcalls and huzzahs, with critics saying the Fed was dooming the country to debilitating inflation and supporters saying it was sensibly encouraging economic growth. Some veteran Fed watchers, however, complained that Chairman Ben S. Bernanke was revealing too much about the board's thinking, which used to be cloaked in the kind of secrecy reserved for missile launch codes and CIA threat assessments. The openness brought about by Bernanke carries risks, but the potential benefits are greater. At the very least, it should help dispel the mystery that fuels investor speculation and undermines the effectiveness of the nation's central bank.

Lawmakers have given the Fed two equally important but occasionally conflicting missions: to minimize inflation and to maximize employment. It tries to fulfill those tasks by influencing the supply of dollars available to banks and borrowers. To oversimplify, that entails lowering the cost of money by increasing the supply when the economy is weak and unemployment is high, and doing the opposite when inflation rears its ugly head.

The Fed's main tool is the target it sets for the federal funds rate — an interest rate for bank-to-bank lending that strongly influences other short-term rates. The Fed doesn't have the power to dictate the federal funds rate, however; instead, it buys or sells government securities as needed to push the rate up or down toward its target. Since December 2008, the Fed has kept its target at 0% to 0.25% in an effort to stoke growth.

Before 1994, the Fed didn't even disclose its target for the federal funds rate. Since then it has gradually shed more light on its maneuvering, but typically after a long wait and with few details. Fed officials apparently believed that their opacity would give them more freedom to maneuver without disrupting financial markets. As a result, however, investors made bets based on rumors and assumptions about interest rates. And when the Feds' infrequent disclosures didn't match investors' expectations, the markets gyrated.

Bernanke, who became chairman in 2006, has fought to keep a tight lid on some of the Fed's activities, such as the loans it offers to cash-strapped banks. But he's pressed the Fed's board to explain its actions on interest rates, even holding news conferences after board meetings to elaborate on its announcements. He also urged the Fed to announce a target for inflation as well as one for short-term interest rates, on the theory that public expectations help determine how much prices will rise. If people expect prices to remain stable, they won't do things that promote inflation, such as demanding higher prices for their goods in long-term sales contracts.

Opponents of the new transparency argue that if the Fed doesn't hit its publicized inflation target, it will lose credibility and influence over credit markets. That's a real hazard, but it's one the Fed already faces when inflation skyrockets, as it did in the 1970s, or asset bubbles explode, as they did in the 2000s. So it was a welcome development when the Fed announced its first formal target for inflation: 2% annually. Making this goal public "helps keep longer-term inflation expectations firmly anchored," as the board put it, which should help the central bank as it strives to promote growth.

The board also announced that it expected to keep its interest rate target at "exceptionally low levels ... at least through late 2014." That's an unusually clear window into the Fed's thinking about the long term, and it could promote economic growth by encouraging lower interest rates on long-term loans. That, in turn, should spur businesses to invest more. It's not good news for savers, but it is for borrowers.

To provide even more guidance, the Fed disclosed the range of economic forecasts its members and the bank's presidents had made, along with their projections for when the federal funds rate should be increased. As the disclosures show, the Fed isn't all-seeing and all-knowing. It works from a range of economic forecasts, not stone tablets. But by acknowledging its internal uncertainties, the Fed tells the public that its position can and will change as new information comes in and its consensus shifts.

Some critics contend that by disclosing more and more about its expectations, the Fed is tying its own hands — it wouldn't dare change course for fear of causing financial markets to overreact. But markets already overreact when the Fed does something investors and borrowers didn't expect. It's far better to have those expectations based on actual data from the Fed, not speculation about where the central bank might be headed.

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