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New Fed forecasts: Transparency or distraction?

January 11, 2012

| MoneyRates.com Senior Financial Analyst, CFA

As part of Ben Bernanke's commitment to increasing the transparency of the Federal Reserve decision-making process, the Fed will begin releasing regular forecasts of interest rate expectations. While the goal is to give more weight to Fed decisions by trying to manage investor expectations, there is a possibility the move could backfire.

Regardless of what the Fed does, interest rate markets will remain anticipatory by nature. The problem is, when the Fed forecasts future changes in interest rates, it may spark an anticipatory reaction by the financial markets that undermines current interest rate policy.

Influencing behavior

On January 3, the Fed released details from its December meeting that included plans for the new forecasts. These forecasts will show the range of predictions made by Fed officials regarding the level of short-term interest rates over the next three years. The first of these forecasts is scheduled to be released on January 25th.

These forecasts could well influence investor behavior. For example, a forecast of extended period of low interest rates could influence bond market investors to buy longer-term bonds. Similarly, bank customers looking at such a forecast might be more inclined to lock money up into 3-year CDs, rather than keeping money in savings accounts or money market accounts. The idea would be to capture the higher rates associated with long-term CDs, rather than retaining the flexibility of savings accounts during a period when interest rates are not expected to change much.

Unintended consequences

At best, the Fed's new forecasts might aid financial decision-making, and reinforce the impact of Fed policies. However, there are some unintended consequences that could hurt both investors and the Fed's mission.

For example, what if the Fed forecasts rate stability, but then is forced to raise rates in reaction to changing conditions? Will it lose credibility among investors and bank customers who have made decisions based on the original forecasts? Will the Fed be under public pressure to adhere to its original forecasts, thus slowing its ability to adjust policy to economic conditions?

Also, the Fed has made the decision to release these forecasts at a time when it clearly expects an extended period of low interest rates. If investors use these forecasts as a guide, the effect should be to reinforce the impact of the Fed's low interest rate policy. However, what will happen when the Fed starts to forecast rising interest rates a year or two out?

Again, markets are anticipatory, so once the Fed begins to forecast higher interest rates in the future, bond yields may start to rise immediately. This would counteract the effect of the Fed's current interest rate policy. In practice, could be very difficult for the Fed to forecast future changes without those forecasts starting to impact immediate policy.

In short, the Fed's job is tough enough as it is. Releasing detailed interest rate forecasts is an unnecessary complication that might only make that job tougher.

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