Federal Reserve officials, disturbed at what they view as the financial markets' overreaction to recent announcements about which way they were leaning on future interest rate targets, said yesterday that they have adopted a new procedure.
Beginning with its next meeting on Feb. 1 and 2, the Federal Open Market Committee, the central bank's top policymaking group, will no longer adopt monetary policy directives that include a formal "bias" regarding rates. Instead, a Fed statement said, the public announcement will focus on the FOMC's "assessment of the risks to satisfactory economic performance."
The change reflects Fed officials' realization of the power of the markets in the economy. They feel that "transparency" about their thinking is good for financial markets and the economy, but only if the markets read that thinking correctly.
Under the new policy, officials at each FOMC meeting will choose one of three phrases to insert in the middle of the following paragraph: "Against the background of its long-run goals of price stability and sustainable economic growth and of the information currently available, the committee believes that the risks are:
* Balanced with respect to prospects for both goals, or
* Weighted mainly toward conditions that may generate heightened inflation pressures, or
* Weighted mainly toward conditions that may generate economic weakness in the foreseeable future."
Yesterday's statement noted that "previously, the committee's directive and statement referred to the relative likelihood of an increase or a decrease in the intended federal fund rate [the rate financial institutions charge each other on overnight loans], which may have intensified the public focus on the chance of a subsequent" change in rates.
That increased "the possibility of misperceptions about the odds and the timing of policy action." For example, when the FOMC announced last May that it had moved from a neutral position to one that included a bias in the direction of raising rates the financial markets generally reacted as if the FOMC's target for overnight rates had already been increased.
After target rates were raised at the end of June, the committee went back to a neutral directive. This wasn't done because officials thought that only one increase was going to be enough, but because they feared markets would again overreact, some FOMC participants said at the time.
Yesterday's statement said the new procedure of announcing a view that risks are "unbalanced would not necessarily trigger either a current or a subsequent policy move; given the inherent uncertainty about future developments, policy actions often importantly depend on the flow of new information and the FOMC's judgment about its implications."
The new approach was worked out by a group of FOMC participants headed by Fed Vice Chairman Roger W. Ferguson Jr. and adopted at a December meeting.
Ferguson told reporters yesterday the Fed is "trying to be clear that there is a more attenuated link between statements and the future path of interest rates" than the market seemed to assume last year.
"We are not trying to deny there is such a link," he added. But he cautioned that historically interest rate moves have occurred only about half the time that the FOMC has adopted a bias in one direction or the other.
It is not clear whether the markets would read the same distinctions into the new language that Fed officials intend.
"All they've done is change the wording they use," said Jim Glassman, senior U.S. economist at Chase Securities Inc. "Market types are going to translate these words into tightening, easing or neutral stance. It's going to have the same meaning to them."
David Hale, chief economist for Zurich Group, said, "I don't believe this is going to be a material change for the market. I think it's an attempt to embellish the bias and make it a little bit clearer."
A complicating problem under the old announcement procedure was that even among officials on the committee, there was no agreement on the time period covered by the directive and any bias. The language of the directive said it applied only until the next meeting and many participants thought of it in those terms. But others thought of it as a more general statement--similar to what will now be included in the paragraph above--that applied to a longer period of time.
As for the period to which the new assessments of the balance of risks will apply, the Fed explained, "Although 'the foreseeable future' is intended to convey a length of time extending beyond the next FOMC meeting, the concept is necessarily elastic, given that the relevant horizon may depend on economic conditions."
Mickey Levy, chief economist for Bank of America in New York, praised the new approach on public announcements. "The Fed is pursuing its goal of transparency but refining its previous procedure of using the bias because it had clear faults," Levy said.
"In effect, the Fed will be using more elastic language and not focusing exclusively on what they are going to do at the next meeting," he said.
In its statement yesterday, the Fed stressed that elasticity: "The phrase 'weighted mainly toward' is included in the wording to underscore that in balancing the two separate types of risks, the committee in some cases may view both risks as being present but one type of risk as outweighing the other."
In other words, the policymakers could confront a dilemma in which inflation is or is threatening to increase at the same time there are signs the economy is weakening. Officials then would have to decide which risk appeared to be greater.
Staff writer John Burgess contributed to this report.