Secret of the Up-or-Holding Rate: Tuesday's Fed Mystery Theater

By Nell Henderson
Washington Post Staff Writer
Friday, August 4, 2006

Federal Reserve policymakers haven't provided a wink, a nod or even a coded phrase to telegraph what they plan to do with interest rates when they gather Tuesday -- the first time in three years the outcome has been uncertain so close to their meeting.

The reason, analysts say, is simple: Fed members themselves don't know, with some pressing for the 18th consecutive increase in interest rates and others ready for a break.

But the situation reflects something more: a shift in the Fed's communications strategy. Instead of providing short-term guidance about interest rates, the new chairman, Ben S. Bernanke, is highlighting a long-range view of where he wants the economy to go over 18 months or longer.

That contrasts with the practices of his predecessor, Alan Greenspan. In his last 2 1/2 years as chairman, Greenspan sent clear signals ahead of time to prepare financial markets for Fed decisions on interest rates. Bernanke continued that policy when he took over in February.

If Bernanke sticks with the new approach, stock and bond investors will have to do a lot more guesswork about where interest rates are headed.

Bernanke used his most recent public appearance July 19 on Capitol Hill to highlight the Fed's economic forecast over the coming 18 months. In doing so, he outlined the collective goal of the policymaking Federal Open Market Committee: a so-called "soft landing" in which the economy slows down just enough to tame inflation without sliding into recession.

And he said the forecast represents what the policymakers expect to happen if they adjust interest rates just right -- without saying specifically how they will do so.

This approach is called "inflation forecast targeting" by Fed economists and academics. By contrast, Greenspan didn't play a role in drawing up the Federal Open Market Committee's economic forecasts, and often ignored them in talking to Congress. He was generally skeptical of economic models and frequently questioned the Fed staff's forecasts.

Financial markets rallied strongly when Bernanke appeared before Congress, in large part because his testimony implied that the Fed doesn't plan to raise rates more aggressively this year to bring down inflation faster. By yesterday, traders in futures markets were pricing in about a 60 percent chance that the Fed will leave its benchmark rate unchanged Tuesday at 5.25 percent, and about a 40 percent chance it would raise the rate to at least 5.5 percent.

The communications shift reflects the Fed's growing uncertainty about when to stop raising interest rates.

With the economy losing steam and inflation accelerating, the Fed does not want to raise rates too much and tip the economy into recession, or raise rates too timidly and let inflation get out of control.

"If you don't know which way you're going, it's hard to send up a flare," said former Fed vice chairman Alan S. Blinder. "This is pretty close to a 50-50 call."

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