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Bernanke Opens the Black Box

The Fed will publish the interest rate outlooks of its top officials.

Federal Reserve Chairman Ben Bernanke is looking rather Swedish these days. Before entering government, Bernanke was a leading academic exponent of inflation targeting as practiced in Sweden, New Zealand, Britain, Canada, and the European Central Bank. It’s a transparent approach to monetary policy that steers interest rates to keep the long-term inflation trend within an announced range. Bernanke set aside his plans for inflation targeting during the financial crisis, when he adopted heroic, ad hoc measures to save the big banks and rescue the global economy.

Now the quiet, circumspect chairman is going back to the commitment to transparency that he developed during his days teaching and researching economics at Princeton University. For the first time ever on Jan. 25, the 17 Federal Reserve governors and bank presidents will state their views on the appropriate course of the federal funds rate, the short-term interest rate that the Fed controls. Those forecasts will be collected and published, albeit without names attached.

“This is Bernanke getting away from the Greenspan model, the oracle, the guru,” says IHS Global Insight (IHS) U.S. Economist Paul Edelstein. In a note to clients, Edelstein called it “a giant step toward enhancing the clarity and transparency of monetary policy.”

To fight the economic slump and financial crisis, the central bank lowered the federal funds rate to a rock-bottom 0 percent to 0.25 percent at the end of 2008 and has kept it there, saying economic conditions “are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.” Markets are now betting that the rate won’t go up until sometime in 2014. The new communications strategy will give dovish Fed voters a way to express their determination to keep rates tied to zero even past 2013.

The big idea is to fill a blank in the way the Fed makes its quarterly economic forecasts. (All 17 top officials participate in the forecast, even though the rate-setting Federal Open Market Committee has only 10 members—the five governors in Washington and five at a time of the 12 regional bank presidents.) The officials are currently instructed to assume “appropriate monetary policy” when they forecast economic growth, unemployment, and inflation. That is, they’re told to assume what should happen, not what they think will happen.

That can lead to confusion. For example, a Fed official who favors higher interest rates might predict inflation will stay mild—but only because he’s basing it on the (unrealistic) assumption that the FOMC will side with him and raise the federal funds rate substantially to chill the economy and keep prices from spiking.

Starting with the January meeting, the public will actually be told what Fed officials assumed about “appropriate monetary policy” when they made their economic forecasts. They still won’t be told who made which forecasts. Some participants in the December meeting worried that the new information “could confuse the public,” according to the minutes released on Jan. 3. “They have been pretty naive about how they’ve approached this whole communications policy,” says a frequent Fed critic, Robert A. Eisenbeis, chief monetary economist of Cumberland Advisors, a Vineland (N.J.) investment firm.

On the whole, Bernanke’s quest for transparency is a plus for investors and economists. It could cause headaches for the chairman. Now that Fed officials are asked—nay, required—to divulge their preferences on the long-term path of the federal funds rate, those who disagree with Bernanke may find it harder to swallow their pride and vote with him for the sake of unanimity.

Bernanke isn’t likely to lose a vote—this isn’t the Supreme Court, where Chief Justice John Roberts often finds himself in the minority—but “it could complicate his life a bit,” says Jan Hatzius, chief economist of Goldman Sachs (GS). To Bernanke, still a professor at heart, that’s a small price to pay for a more predictable central bank.View From the Fed

Fed officials forecast GDP, unemployment, and inflation. In January they will reveal the “appropriate monetary policy” they assumed in making these forecasts.

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