Federal Reserve Chairman Ben S. Bernanke makes no secret of his desire to improve the transparency of central bank policy communications with respect to conveying the near-term course for monetary policy. To that end, investors continue to focus their attention on the monetary policy communication issued at the conclusion of each Federal Reserve Open Market Committee (FOMC) meeting as the centerpiece of such improved clarity. But I believe doing so artificially constrains Dr. Bernanke’s intention. In fact, I think it reasonable to argue that more complete and in-depth rationale for past and future policy actions now regularly appear, with Dr. Bernanke’s knowledge, within FOMC member speeches and research papers.
While subtlety and veiled inference have long been a part of central bank communication, my experience over the years of monitoring policy directives gives me reason to suggest there is always more than one nuanced sentence that is just as important, if not as striking, as the one making headlines. Simply put, investors who attempt only a cursory reading of the policy directive risk missing important information.
You see, as investors quickly parsed the latest FOMC directive on October 31, 2007 in search of the obvious—“The Committee judges that, after this action, the upside risks to inflation roughly balance the downside risks to growth,”—a sentence from the second paragraph—“Today’s action, combined with the policy action taken in September, should help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and promote moderate growth over time”—went virtually unnoticed. Though appearing to be nothing more than an obscure macroeconomic reference to past events, I suggest this sentence to be the real message on future FOMC policy actions.
Furthermore, recent FOMC member research papers and speeches add weight to that message. A recently published working paper from FOMC governor Frederic S. Mishkin explores the optimal response of monetary policy actions to offset a dramatic decline in real (inflation-adjusted) housing prices. His conclusion, following a complete historical and theoretical review of alternative approaches in conjunction with data produced by the FOMC’s own econometric forecasting model FRB/US, is stunningly straightforward: “optimal policy can be extremely successful in counteracting the real effect of this very large housing slump.”1
If I am interpreting Governor Mishkin’s research correctly, an FOMC faced with the potential for a quantifiably large decline in housing prices should not favor a moderate and measured policy response. Rather, the optimal policy becomes aggressive, preemptive (early) and open-ended with interest rate reductions sufficiently large to forestall potential adverse repercussions to employment, consumption and economic growth. And, as Mr. Mishkin suggested in a speech on November 5, 2007, if the proactive rate cuts prove to be too little or too large, policy actions are not inflexible or irreversible.
Perhaps, the most telling statement on why investors should not conclude further rate reductions unlikely comes from Mr. Mishkin’s October 26, 2007 speech titled, “Financial Instability and the Federal Reserve as a Liquidity Provider.”2 Here, he stated, “Congress has given the Federal Reserve a dual mandate to achieve both price stability and maximum sustainable employment. The Federal Reserve’s role as a provider of liquidity to cope with episodes of financial instability has been and will continue to be, critical to its success in achieving this mandate.”
Could the Fed’s intention in light of ongoing developments in the nation’s housing sector be any clearer? I think not.
1 Mishkin, Frederic S., “Housing and the Monetary Transmission Mechanism,” Working Paper 13518, National Bureau of Economic Research, October 2007, page 37. Available at http://papers.nber.org/papers/w13518
2 Mishkin, Frederic S., “Financial Instability and the Federal Reserve as a Liquidity Provider,” speech delivered at the American Museum of Finance in Commemoration of the Panic of 1907, New York, New York, October 26, 2007. Available at http://www.federalreserve.gov/newsevents/speech/mishkin20071026a.htm
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