The Fed Needs a Spine

Monday, August 13, 2012

Ben Bernanke announced in January that the Fed’s Open Market Committee would begin publishing its views on future interest rates. But he added a key caveat: the assessments “should not be viewed as unconditional pledges.” Instead, he said, they “are subject to future revision in light of evolving economic and financial conditions.”

By publishing interest-rate expectations, the Fed aims to impair its future flexibility—but not too much. The benefit of this self-restraint is to come from the greater clarity that businessmen and other private-sector decision makers have about future Fed actions. Too often in the past, the Fed and other central banks have succumbed to political pressure to deviate from their announced commitments.

But the costs of this move by the Federal Reserve will outweigh the benefits unless the public understands how the Fed is likely to respond to unexpected economic developments, even as it tells everyone more about what it expects. The problem is that some deviations from an announced “path” of future interest rates might be unwarranted, while others would be entirely appropriate as new information appears and events unfold.

The Fed’s challenge is to distinguish between appropriate and inappropriate responses, and to convince the market and other branches of government that it will behave accordingly.

Too often, the Fed and other central banks succumb to pressure to deviate from their announced commitments.

That task would be easier if the Fed were truly independent, but it is not. Congress created the Fed and can abolish the central bank by a simple majority vote. Public pressures—as well as confrontations with presidents and Congress—to avoid high interest rates have derailed the Fed’s best intentions throughout history.

Paul Volcker, who restored price stability during his term as Fed chairman, honored President Carter’s request to support the imposition of credit controls in 1980 to avoid still-higher interest rates. Volcker considers this episode, which delayed his anti-inflation crusade, “a great mistake.” While no president is known to have explicitly pressured Bernanke’s predecessor, Alan Greenspan, he found it easy to maintain low interest rates for too long, fueling the credit boom and housing bubble that led to the financial crisis in 2008.

We fear that the president and Congress will dismiss justifications for higher interest rates that might be appropriate before the economy returns to full employment.

Bernanke announced his new policy to disclose the committee members’ interest-rate assessments immediately after the Fed reported the committee’s conclusion that “economic conditions” would be “likely to warrant exceptionally low levels for the federal funds rate at least through 2014.” Headlines trumpeted this likelihood as a “vow” to keep interest rates low. In March, the Open Market Committee repeated its expectation of “exceptionally low levels for the federal funds rate at least through late 2014.”

Our fear is that the president and members of Congress will dismiss justifications in the future for higher interest rates that might be appropriate before the economy returns to full employment. With the memories of recession still fresh, Americans might not tolerate the pre-emptive restraint needed to maintain price stability.

Bernanke could have deflected future complaints by saying: “We too know that financial forecasting is difficult; it is an exercise that becomes more uncertain the further into the future we go. While interest rates are close to zero now, we know they will not remain this low when the economy recovers, and we hope that recovery will occur faster than anticipated. The jumps in interest rates when recovery occurs will be smaller if Congress and the president balance the full employment budget, so that government borrowing contracts as corporations and individuals enter the credit markets.” This is a message that would have made Congress and the president accountable as well.