Risks of the Fed Unmasked

Once he steps out from behind the curtain, the wizard is just another old man.

The Federal Reserve has gone to great lengths to make its monetary policy intentions more transparent. The question as the Fed gathers for its next meeting Tuesday is whether that is such a good thing.

Consider changes already made under Chairman Ben Bernanke: The Fed now publishes its economic projections and holds quarterly news conferences. Soon, it may go so far as to publish fed-funds-rate projections—that is, to telegraph its intended path for interest rates.

Two decades ago, statements to the public following policy decisions were rare, short and terse. This is an example from early 1994: "Chairman Alan Greenspan announced today that the Federal Open Market Committee decided to increase slightly the degree of pressure on reserve positions. This action is expected to be associated with a small increase in short-term money market interest rates." Got that? Few did. The Fed's interest-rate increases that year, in fact, caught investors by surprise, routed bond markets and helped precipitate the bankruptcy of Orange County, Calif.

To prevent a repeat of such turmoil, and lately to help fend off political pressure, the Fed has become increasingly open about its methods. Whereas Chairman Greenspan often intended to make his views difficult for the public to divine, Chairman Bernanke wants to make sure everybody can read his lips. An additional motivation for this today is to "talk down" long-term interest rates now that short-term ones are essentially zero bound.

Over time, though, these benefits might not seem so great. For starters, it won't take long for the public to realize the Fed's economic forecasts are no better than the average economist's. The Fed could also get boxed in if, for example, inflation is above forecast and officials still want to loosen policy.

Most important, by so clearly telegraphing its rate intentions, the Fed may foster systemic risk by giving investors a false sense that they are insulated from abrupt market shifts. This Bernanke "put" could potentially be damaging as the desire to shield financial markets may actually encourage them to take ever greater gambles.

The Fed may have only the best intentions for the American people in mind, but in practice risks doing less and less good for them.

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