When the Fed finally raised its target interest rate in December, it capped off a months-long period of speculation and anticipation among analysts. Many Fed watchers had predicted a September rate hike that ultimately didn’t take place; others looked at the mixture of volatile equity markets and signs of economic recovery and wondered if December was too soon. Despite Ben Bernanke’s concerted efforts, as Fed chairman, to be “more transparent” and Janet Yellen’s willingness to follow down that path, the Fed still retains its capacity for surprise.
This might be a good thing. Central bankers should be clear about how they expect their choices will affect the economy, argue Alexander P. Frankel of Chicago Booth and Navin Kartik of Columbia, but may want to keep their inflation target, and other policy preferences, to themselves.
When a central bank makes a decision, Frankel and Kartik say, the public is faced with a conundrum. Is the bank acting on a policy preference such as a tolerance for higher inflation, or is the bank acting in response to private data? This confusion serves a purpose when a central bank has to act without spurring excess inflation.
If the bank signals that it has made a policy change in response to private data, the public’s inflation expectation becomes more responsive to monetary policy given greater uncertainty about the Fed’s policy preferences. When the bank adds additional transparency, such as an inflation target, to the mix, the public becomes less responsive to the bank’s decisions. If the public knows, for example, that liquidity injections will continue until its inflation target is reached, there is no urgency to act on what the bank is doing now. This means the bank has to inject ever more liquidity to achieve its desired results, which can lead to more inflation than desired.
Adding some opacity forces the public to assume that the bank is privy to information that informs policy and that it should react more quickly to what the bank gives or takes away. As frustrating as it may be, our current debate about when the Yellen lift-off will occur may be a healthy one.