| Alan Greenspan | ||||||
In the central bank effectiveness stakes the European Central Bank has been most often compared – generally unfavourably – with the US Federal Reserve. Certainly the Fed seems more responsive to market movements and talks to the market rather a lot too. But then how effective is all this communication?
“Loose lips sink ships” was the wartime watchword in official Washington. But who would know it today? The formerly secretive Federal Reserve doesn’t seem the least bit concerned when its people speak their minds in public. So a veritable cacophony of views sometimes gushes forth from the US central bank.
The Fed’s new-found gift of the gab doesn’t seem to have done any harm – at least not yet. “The dollar remains firm against the currencies of nominally hawkish central banks,” says John Makin, an economist at Caxton&Co in New York who spends part of his time as a policy expert at Washington’s American Enterprise Institute, “even though the Fed has eased aggressively, while most measures of inflation have been stable to higher. It’s a tribute to the Fed and its ability to communicate with the markets.”
But the trade-offs between careful choreography and letting it all – or most of it – hang out have become plain for all to see. For example, William Poole, president of the Federal Bank of St Louis, told reporters that he preferred it if there were no interest rate changes between scheduled meetings of the Federal Open Market Committee – this a few days before Federal Reserve chairman Alan Greenspan announced April’s surprise rate cut following a conference call with the FOMC.
“The Fed’s noise-to-insight ratio can seem high, with so many voices,” says Michael Prell, long-time head of the Fed’s research and statistics division, who retired last year. “But the market probably can best anticipate the outcome of the decision-making process if each participant gives a reasonably complete account of his thoughts, however idiosyncratic. If the Fed finds that this leads merely to public confusion, it may conclude that it would be worthwhile devoting some effort to reaching greater agreement on fundamental issues.”
The Poole episode was a rarity, says Henry Kaufman of the New York advisory firm that bears his name. “Notice that the chairman has one vote,” Kaufman points out, “but there’s more than one vote. His colleagues on the board call him ‘Mr Chairman’. So it’s quite obvious how important that one individual is. This chairman always has been on the majority side or at least he has never had a vote go against him in the disclosure sense.”
Kaufman thinks that there is adequate coordination in the FOMC because the view of the chairman dominates. The view that comes out of the New York Fed is also important. “I have never seen a president of the Federal Reserve Bank of New York disagree with the Fed chairman,” Kaufman continues. “That’s very important because New York is dominant among the regional Federal Reserve banks.”
Still, dissent within the FOMC will cause ambivalence in the minds of the market. “I think that is very difficult to control,” observes Kaufman, “when you have competent people sitting on the board.”
Poole told a conference at the American Enterprise Institute earlier this year: “One of the big surprises when I arrived at the St Louis Fed was just how difficult it is to explain what we’re doing.” Poole makes a point of asking himself whether he’s surprised by the market reaction as he listens to the radio at 2:15pm after every FOMC meeting. “I rarely have any solid idea as to the magnitude of the response and I’m sometimes surprised by its direction,” he reflects. “But if we don’t know what the market response is going to be, then clearly we’re not communicating very effectively.” Poole thinks that the key to having more predictable effects on the market is to use more standard wording in the announcements.
The Fed’s procedures could do more to keep the markets informed. The FOMC meets eight times a year and usually issues a brief statement following each meeting. It then publishes detailed minutes six to eight weeks later, complete with a record of how each member voted.
The ECB, however, has taken a deliberately more focused approach than the Fed. But it’s also less transparent about its deliberations. The ECB meets twice monthly and keeps markets up to date by issuing a statement after each meeting followed by a press conference by its president. The ECB doesn’t release details of the votes of its members, and apparently makes most decisions without actually voting.
But ECB officials haven’t exactly been inhibited about speaking their minds. “Coming from diverse backgrounds, they appear less coherent and coordinated than the Fed,” says Richard Berner, a Fed watcher at Morgan Stanley.
Berner doesn’t think that the Fed has got it totally right. “But it seems to be working a little bit better than some of the others,” he says, “because policy makers are flexible and forward-looking”.
Communication is a two-way street. So, how much weight should a central bank give to signals from the market? “The Fed must recognize that market expectations affect the outcome of its actions,” Prell reckons. “It behoves the Fed to provide credible information about its ultimate objectives, because that will at least minimize one potential source of error in those expectations.”
Prell points out that market prices can embed views about economic fundamentals that are not well founded. So he argues that they should not necessarily be given overwhelming weight. “Sometimes, Fed policy makers do indeed have a better grasp of things than do private price setters,” says Prell, while admitting that it’s not fashionable to make such an assertion.
The Fed is a market observer, a listener and collector of information. It is not an everyday market participant, buying and selling securities. So, it is trying to find out from the market what is happening and doesn’t have really instantaneous news of what’s going on in the market.
“But neither does anybody in the market have a full comprehension of what’s happening in this total market,” Kaufman points out. “Sometimes a major institution sees what’s going on and it may relate that to the Federal Reserve. In that sense, the market may have an advantage. But those are fleeting events, rather than overbearing events.”
The new openness from the authorities has eroded the importance of outside analysts that earn their living as central bank watchers. But that same openness has also upgraded the role of the press in transmitting policy to the marketplace – provided, of course, there’s time to add value before journalistic deadlines.
Is today’s love affair between the Fed and the markets headed for the rocks? For now, the markets clearly like the way that the Fed has been talking. “I don’t think there’s any way that today’s close relationship between the Fed and the markets can or should end,” says Berner. “Policy makers understand that globalization, integration of financial markets, securitization and financial innovation mean that they cannot fight market forces as perhaps they could 30 years ago. Markets can be either their allies or their enemies. I don’t see that any policymakers expect to be able to conduct monetary policy effectively without having the markets on their side.”
But Kaufman thinks that this period of good feeling would come to an end if the US economy were to slide into recession. “Some of the store of goodwill that the Fed has garnered will diminish,” he says. “The Federal Reserve has at least played a role so far in preventing a recession in the US, but bad economic news always puts the Federal Reserve under scrutiny.”
For now, the person of Alan Greenspan is an enormously valuable asset. “I think the chairman’s capacity to expound on economic and financial developments has improved over the years,” says Kaufman. “If you watch his appearances before Congress today and compare them with his appearances 10 years ago or so, there’s a vast improvement and I think that has had some influence.”
