The Federal Reserve will welcome a new Chairman, Ben Bernanke, on January 31, 2006. When outgoing Chair Alan Greenspan’s last term ends, after eighteen-plus years, the Fed will not only experience new leadership, but a shift in emphasis. Does a change in Chairmanship at the Fed make much difference?
Greenspan has been known as a policymaker who liked to fine tune interest rates while also attempting to balance economic growth and overall prices. Bernanke has announced that he favors a policy of maintaining a low—2 percent—inflation rate. Seems subtle, but it’s a real difference , and it goes not only to beliefs about how the Fed operates, but about how markets coordinate people’s plans economy-wide.
The Fed has a responsibility to regulate banks and to control the nation’s money supply. In fulfilling these functions, though, the Fed chooses which macroeconomic variables it will target. Because of the way markets interact, it cannot simultaneously control interest rates, the nation’s money supply, economic growth, and the price level.
It may still surprise some members of the public to learn that the Federal Reserve’s policy-making efforts are mostly conducted in secret. When the members of the Fed’s Open Market Committee meet, as they do every six weeks, they discuss economic conditions in each of the twelve Federal Reserve districts as well as nationwide, and produce economic forecasts for upcoming quarters. To prevent these forecasts from becoming self-fulfilling prophecies, or unduly influencing market decisions, minutes of the Fed’s deliberations are not published immediately after its meetings.
There is a reason for secrecy. The Fed is mindful of the drawbacks associated with rational expectations when it comes to monetary policy. If the public knew for certain that interest rates would rise by a half percent in two weeks, for example, they could take action today to avoid the impact of the change before it became official. That would nullify the intended effect of the policy, so the announcement and the action are taken simultaneously. Even if it is correctly anticipated by market analysts, the public can’t be certain of a policy until after the fact, meaning that it is still possible for the Fed to create an effective policy ‘surprise.’
Bernanke represents a departure from the Fed’s usual policy of avoiding explicit announcements about intermediate goals like inflation rates. While all Federal Reserve policy is ultimately designed to influence variables like investment, inflation, employment or output, the announced target of a 2 percent inflation rate would be much more specific than the typical Federal Reserve approach. Presumably, the Fed would observe actual deviations from the announced inflation rate goal, and use that information to determine the size and direction of policy changes. This could mean increases or decreases in the money supply growth rate, in discount rates, or reserve requirements. For short-term adjustments, changes in the discount and federal funds rates, in preference to the other policy tools, are the preferred options. Reserve requirements and money supply changes take more time to implement, and are slower and more difficult to gauge for short-term effects.
Here’s a quick look at how an inflation rate rule might be applied. If inflation rises above the 2 percent target for a specified number of weeks or quarters, the Fed will try to slow demand for goods and services, or boost production. Practically, it’s not possible to boost short-run output economy-wide, so dampening demand—making credit more scarce and boosting interest rates—is the likely short-term course. The current Fed has raised interest rates twelve consecutive times in similar concerns over inflation. Once inflation returns to an acceptable range, the Fed could reverse course, lower interest rates, hold them steady at current levels, or flip-flop the direction of change whenever and by whatever interest rate increment it feels is necessary, to hold inflation at the 2 percent target.
How does this differ from the current Federal Reserve policy? If the 2 percent rule is really a rule, a sharp change in the nation’s overall unemployment rate would not cause a change in interest rate policy, for example. A change in the rate of price inflation, regardless of how unemployment is behaving, should.
What is missing in these oversimplified descriptions of Fed policy is the understanding that macroeconomic variables like unemployment and national output are not only interconnected, but that they are profoundly influenced by events on the microeconomic level. Future Minutes will try to take up some of the many missing pieces in this discussion.