More Fed Transparency?

I just finished reading this articleover at Yahoo! Finance that the FOMC has moved to increase both the frequency and long-term outlook of the Fed’s publicly released economic forecasts.  All this, Chairman Bernanke says, will make it easier for the Fed to do its job by increasing the lines of communication between the central bank, investors, and consumers. 

So to a certain extent I can buy that greater transparency on the part of the Fed is good.  When markets are able to make more reliable predictions of interest rate activity, firms and consumers can adjust their investment and spending decisions accordingly.  This will decrease the intensity of a policy shock on the economy, insofar as the latter can impose growth-mitigating volatility on the economy.  It should also increase accountability, which I’m sure makes some people quite happy. 

However, I think there are some important drawbacks to still greater transparency on the part of the monetary authority.  For one thing, when the Fed does not act as expected, the adjustments that markets will make will be far more drastic as participants – firms and governments (both international and domestic) and consumers – will have likely developed more unflexible forecasts – explicit or implicit – of interest rates;  that is, greater transparency may reduce the flexibility of market participants thereby creating the risk of high degrees of volatility when the Fed does not act as suspected.

The other problem, which I think is less understood and perhaps therefore more insidious, is that as the Fed increases transparency it risks its position a source of nominal changes in the economy and instead becomes nothing more than an instrumental variable in market decisions.  In econometric-speak, Fed actions may lose their causal link to economic activity and instead become only highly correlated with it.  To the extent then that households now rely, with justification, on changes in Fed policy to make investment and spending decisions, they will become unmoored from this bastion of economic stabilization.  Might the federal funds rate go the way of the yield curve as those who have come to rely on it to make safe bets on the economy will at some point in the future find themselves suffering huge losses due to their suddenly-unfounded faith?  I think it’s possible. 

Greater transparency is a victory for the free-marketeers at Cato (which is where, incidentally, Bernanke announced this decision), but it may have unintended consequences the magnitude of which we can only begin to guesstimate.  One I can think of off the bat is that more impetus may fall on government to affect the economy through fiscal policy.  That’s not going to make Cato, Bernanke, or any other free-market advocate, very happy. 

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