Fed transparency: Too much of a good thing?

Despite taking pride in his ability to “mumble with great incoherence,” former Federal Reserve Chair Alan Greenspan initiated the Fed’s path toward greater transparency over 25 years ago.

Until the early 1990s, investors counted on Wall Street "Fed watchers" to decipher the often cryptic monetary policy messaging conveyed in Fed open market operations (i.e., the buying and selling of Treasuries).

Policy changes were made without formal announcements and were frequently implemented outside of scheduled Federal Open Market Committee meetings. Even experienced Fed watchers occasionally misread what Fed open market operations meant for monetary policy.

Under Greenspan’s leadership, the Fed implemented a number of significant changes to improve transparency. Publication of FOMC meeting minutes began in 1993 and was followed the next year by public announcements of all policy changes after meetings. In 1999, the Fed also started to issue FOMC meeting announcements that communicated no change in policy.

The committee issued its first forward policy guidance following the August 2003 meeting with the statement, “Policy accommodation can be maintained for a considerable period.” According to former Fed Chair Janet Yellen, this statement completed the Fed’s journey “from ‘never explain' to a point where sometimes the explanation is the policy.”

Greenspan’s successors Ben Bernanke, Janet Yellen and Jerome Powell have all embraced the push for greater transparency. Recent enhancements to Fed communications include post-meeting press conferences (after every FOMC meeting starting this year, the first year in which there will be a post-meeting press conference after all eight Fed meetings. It was only quarterly in the past), the quarterly release of economic projections and publication of forward policy guidance in the form of interest-rate path projections — the so-called “dot plot."

Today, Fed transparency has moved beyond helping investors better understand its stance on monetary policy to more frequent and detailed economic projections. The Fed’s forecasting accuracy, by its own admission, has been disappointing – with its failure to predict the 2008 financial crisis topping the list.

Coming out of this crisis, the Fed has consistently been too optimistic regarding both economic growth and inflation in the United States. Even the Fed’s ability to predict the level of short-term interest rates, ultimately under its own control, has been an issue. Market forecasts for central bank policy, as measured by the pricing of Fed funds futures, have proven to be a more reliable predictor. Even using a recent average of interest rates plus a random guess has a better track record than Fed projections.

The dramatic U-turn in monetary policy guidance since October 2018 represents the latest failure by the Fed to anticipate a slowdown in growth and inflation already priced into financial assets. Falling Treasury yields and rapidly declining equity and commodity prices, coupled with a potential yield-curve inversion, “flashed red” in December when the Fed followed through on its well-telegraphed rate hike. Declining inflation expectations, emphasized just months earlier in Powell’s Jackson Hole speech, also argued for a quicker Fed pivot to patience on rates, and turning balance sheet reduction off autopilot.

Fed Chair Greenspan, the man who spearheaded the Fed’s path to greater transparency, warned of the predicament the Fed finds itself in today. In his 2001 speech on Fed transparency, Greenspan expressed concern “that being too explicit about short-run targets would make such targets difficult to change, impeding necessary adjustments to evolving market and economic conditions.” Despite almost every market indicator suggesting patience, St. Louis Fed President James Bullard recently suggested that market expectations for a December hike effectively “put the Fed in a box” and influenced the December FOMC decision.

After its sudden pivot on monetary policy, Powell recently said the Fed’s dot plot has become a “source of confusion” for investors. If the Federal Reserve wants to salvage credibility with investors and truly be data dependent as policymakers frequently remind us, the time has come to take a step back on its path toward greater transparency and write the final chapter on the dot plot.

Mark Heppenstall, CFA, is the chief investment officer at Penn Mutual Asset Management.