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December 9, 2005
Wanted: A new "stock phrase"
Greg Ip writes in the Wall Street Journal (full story here)
Since August 2003, the Fed's statement released after each meeting has signaled its next move. Since it began to raise rates from a 46-year low of 1% in June 2004, that statement has described Fed policy as one of "monetary accommodation," meaning rates were below a "neutral" level that neither stimulates nor restrains growth. The statement has also said more "measured" increases were likely, which markets have interpreted as at least one or two more quarter-percentage-point increases.
Given the uncertainty, Fed officials expect to drop or water down their previous language soon. Minutes of the Fed's Nov. 1 meeting, released two weeks ago, showed that "the statement is currently a subject of discussion," Federal Reserve Bank of San Francisco President Janet Yellen said last week. "At issue" are the references to "accommodation" and "measured," she said. "While it seems unlikely that the end of the current tightening phase is yet at hand, there obviously will come a time when these two phrases are no longer appropriate."
The lingering word "measured" reminds me of the old story of the paradox of the unexpected hanging. As the story goes, a condemned criminal is given an unusual sentence by an eccentric judge. He is told that he will be executed sometime next week, but the exact day of the execution will be a surprise. Some versions of the story say that if the prisoner can predict the day of his execution, his sentence will be commuted.
The prisoner reasons that the execution cannot be on Friday becuase if he was still alive on Friday the day would be known with certainty. He reasons that it cannot be on Thursday either since if he were alive on Thursday the execution must be on that day (since Friday is ruled out). Repeating this reasoning (this is called backward induction) the prisoner concludes that the execution cannot happen at all. Satisfied with his reasoning, imagine his surprise when he's led to the gallows at high noon on Wednesday. The judge's sentence was right after all.
It's a paradox.
The word "measured" will not stay in the press statement forever. It has a finite life. For that matter, the interest rate increases will come to an end eventually as well. But when? As it becomes ever clearer that a shift is coming it becomes tricky for the Fed to manage those expectations. They want the flexibility of choosing when to change the policy (or the wording) on their own timetable in response to incoming data without being too hamstrung by market expectations. If they get too predictable, they lose that flexibility. They end up painting themselves into a corner, making the change at the last possible minute (leaving in the word "measured" all the way up to the end of the rate hikes, for example). On the other hand, you don't want to totally surprise the market. It's an even tougher problem than the hangman's paradox.
So how do you maintain your flexibility without introducing too much uncertainty into the bond market? Very carefully. A review of St. Louis Fed president Poole's remarks from this spring are in order. What should the new "stock phrase" be? It needs to have a clear interpretation without being too confining given that we seem to be approaching a shift in policy stance. Comments are open.
UPDATE: Mark Thoma read the same WSJ article and responds,
For now, the problem is how to change or remove the current language without having the market lock into a particular view of future policy. If the market anticipates a particular path as a result of changing or removing the language, say a pause in rate hikes, that would undermine the flexibility altering the language attempts to achieve.
Posted by William Polley at December 9, 2005 12:46 AM
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