Fed Must Juggle Transparency with Flexibility

Federal Reserve chairman Ben Bernanke has made transparency the hallmark of his tenure. That’s why he has done television interviews and started post-meeting press conferences.

But transparency needs to share space with greater flexibility. Investors may prefer defined signposts for the Fed’s next move. But in today’s chaotic economic environment, policy makers need room to shift positions when circumstances change.

In a May 2010 speech, Bernanke explained that policy clarity “reduces uncertainty and–by helping households and firms anticipate central bank actions–amplifies the effect of monetary policy on longer-term interest rates.” Transparency, he said, increases “the ability of policy makers to influence economic growth and inflation.”

The Fed has a legal mandate to pursue price stability and full employment, but its portfolio is broader than that. When a country as small as Cyprus can bring the global financial market to its knees, the world’s premiere central bank has to be ready to change its position to keep the financial system from going over the cliff.

Speaking of cliffs, the Fed also needs to take into account fiscal decisions when making its own monetary decisions.

While Fed officials are unlikely to make significant language changes to Wednesday’s statement, they will eventually have to make it clear to market participants that policy is guided by more than simple target rates for unemployment and inflation in the U.S.

The Fed is clearly aware of the need for elbow room. Witness the caveats the Fed has attached to its measure of labor-market improvement.

The Fed first pointed to a 6.5% unemployment rate as the guidepost for a “substantially” improved labor market. But then the rate fell for the wrong reason: people were dropping out of the labor force. So the Fed added other criteria to show when the labor market was on the mend, including the share of long-term unemployed and the number of people working part time for economic reasons.

Investors want easy-to-follow signposts regarding the next shift in monetary policy. But the Fed knows guiding the economy is a messy business. One size doesn’t fit all.

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