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Skip Navigation LinksHome :: Back Issues :: A necessary element of surprise

May 2001

A necessary element of surprise





The Federal Reserve caught the markets off their guard when it slashed the Federal Funds rate by half a percentage point on April 18.
It was the fourth reduction this year and the second time since January 3 that the US central bank has cut the key overnight rate between meetings of its Federal Open Market Committee. "The April move clearly was a shocker," says David Greenlaw, an economist at Morgan Stanley. "Still, it was less surprising than the cut on January 3 - a move that signalled something had changed, from the standpoint of Fed timing." The Fed had rarely taken such important steps between FOMC meetings, except in times of crisis. So what's going on?
The US has been a leader in the trend away from secrecy in central banking. The Fed changed its procedures as recently as January of last year to be more open about its goals and short-term tactics and gave new priority to making them easier to understand. Surprise, one might expect, would be extremely rare under such a regime.
The Federal Reserve now issues a public statement immediately after every FOMC meeting, disclosing the policy stance adopted by the committee as well as the FOMC's views on the economic outlook. The committee issues this statement whether or not it changes policy or its view about the future. The FOMC has also adopted new and plainer language to describe its sense of the risks to long-run goals, particularly price stability and sustainable growth.
These changes reflect a worldwide movement. Otmar Issing, the ECB's chief economist and a member of its executive board, calls communications the "hidden pillar" of the ECB's strategy. The Bank of Japan has taken steps toward greater openness, following the revision of its governing law in 1998. And the Bank of England Act of 1998, which established the central bank's independence, also beefed up public disclosure.
"They must have been more worried than they've given out in public," one experienced Fed watcher told Euromoney in the wake of last month's cut. Economic conditions had not improved during the month since the FOMC last met. Monthly surveys continued to show that consumer confidence was sagging. Lay-offs were on the rise and a falling stock market was putting a big dent in personal wealth. All of that was bound to affect household spending going forward. Policymakers, no doubt, reckoned that there was less likelihood of a V-shaped recovery in the second half of the year.
"Inventories became uncomfortably high in some sectors," Roger Ferguson, vice chairman of the Federal Reserve, told the National Economists Club. "There also is talk of an overhang of high-tech capital. We are especially concerned about the outlook for capital investments."
The Fed is far more transparent today than in the past, despite the recent surprises. Long-term interest rates in the US began falling last summer in advance of the easing by the Fed that didn't begin until early January. "Long-term rates anticipate future movements in short-term rates and I think that the market has gotten much better, in part, as a result of the Fed's new openness," says another source.
"Prior to 1994, they didn't tell us anything," says Greenlaw, "we were often still debating whether or not the Fed had changed policy a week or so after the fact."
Greater transparency on the part of the central bank, however, does not guarantee that markets will accurately forecast interest rates. One view maintains that surprise has been necessary in these situations because the FOMC didn't like what the markets were expecting. "The purpose was not to catch people unawares," says one student of Fed policy, "but it's important to change the psychology, if markets build in something to the path of interest rates that's not consistent with what the FOMC thinks is going to happen."
Another important aspect of the Fed's recent off-cycle moves is that the only person whose views seem to matter these days is chairman Greenspan. "We had a lot of signals from other Fed officials, governors, and regional bank presidents suggesting that there really was no sense of urgency for inter-meeting action," says Greenlaw. "That was their view, but it wasn't Greenspan's. They really hadn't been clued into his thinking."
Greenspan can exert more control over inter-meeting actions. He has some authority to make decisions between meetings. It's true that the FOMC convened a conference call before both inter-meeting cuts this year and even took a vote before the April move. "He told them what he was going to do," says Greenlaw. "They can object if they wish, but no-one is going to stand in the way when the chairman has decided that a course of action is appropriate in this kind of environment. This was Greenspan's show."
The Fed, no doubt, has found that some degree of surprise can work in its favour from time to time. But there are limits. "You really can risk destabilizing markets much more than you intend," Greenlaw points out, "if you tighten when no-one expects it, and you can't always be transparent when you're in an easing mode or you risk getting very little bang for the buck."
The Fed's Roger Ferguson puts it this way: "The primary task of central banks is to get monetary policy right - that is, to pursue policies that effectively promote the objectives established by their legislatures or parliaments, such as stable prices, full employment, and maximum sustainable growth.
Communicating what the central bank is doing, and why it is doing it, is of secondary importance." JS






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