Originally created 12/13/04

Fed emerging from era of mystery



WASHINGTON - A master of mystery much of the time, Federal Reserve Chairman Alan Greenspan has vastly improved the central bank's communications with Wall Street and Main Street over the past decade.

For most of its history, the Fed committee that sets interest rates has worked in secret, perpetuating the belief that operating like a Sphinx was the most effective way to carry out monetary policy.

"Certainly the view years ago was the Fed ought to try not to communicate its objectives to the market, but keep them as undercover as possible," said Lyle Gramley, a former Fed board member under Greenspan and his predecessor, Paul Volcker.

The current theory, however, is that clearer signals from the Fed about economic conditions and interest rates can help shape public perception and assist the Fed in attaining its goals.

To influence economic activity, the Federal Reserve adjusts the target for the federal funds rate, which is the interest that banks charge each other on overnight loans.

Working to keep inflation in check, the Fed has raised this short-term rate four times this year. Economists are predicting that the Federal Open Market Committee will increase the rate by one-quarter of a percentage point, to 2.25 percent, at its meeting Tuesday.

This rate affects many others: commercial banks' prime lending rate, which is used for short-term consumer and business loans; long-term mortgage rates; and rates on corporate bonds.

"Monetary policy works largely through indirect channels - in particular - by influencing private-sector expectations and thus long-term interest rates," one committee member, Ben Bernanke, said this month.

"Consequently, failing to communicate with the public... only reduces the potency and predictability of the effects of given policy actions," he said.

For a long time, private economists had to monitor the Fed's daily buying and selling of Treasury securities to figure out whether the central bank was changing the funds rate.

"For years, Federal Reserve officials argued that immediate release of policy decisions would make markets more unstable and policy implementation more costly and difficult," William Poole, president of the Federal Reserve Bank of St. Louis and a voting member on the rating-setting committee, recalled in October.

Volcker, in advance of a covert meeting in October 1979, arranged for Fed officials to stay at different Washington hotels.

"I imagine you do know that the Pope is coming in, which may be good cover," Volcker instructed colleagues. "I think there is a need to come in here as inconspicuously as possible."

That meeting set the stage for raising interest rates as high as needed to control escalating inflation.

Lynn Reaser, chief economist at the Banc of America Capital Management, described the Fed's communications policy in the 1970s and the 1980s as a "black box.... It could take a couple of days before we knew what the funds rate target was," she said.

A breakthrough came in 1994 when the Fed began to state when it was changing the federal funds rate. Eventually the Fed began to release statements after each of its eight regularly scheduled meetings a year and did so even when rates held steady.

Over time, the Fed began to give a reason for its actions and a brief assessment of economic conditions. Since early 2002, these statements also include how members voted.

"We have achieved a far better balance, in my judgment, between transparency and effective monetary policy implementation than we thought appropriate in the past," Greenspan said in 2001.

While experts say the Fed has come a long way, the language of monetary policy is not easily understood by the public.

"The average person would think none of this makes any sense - even today," said Brandeis University economics professor Stephen Cecchetti, a former Fed official who has written on the subject of central bank openness.

"If I were to hand the FOMC statement to my mother, she would understand the part about the voting - OK," he said.

Private economists credit Greenspan, the Fed chairman since 1987, with the move toward greater openness. Other countries' central banks also have taken steps to improve clarity.

When Greenspan wants to send a signal to investors, he does. Other times, he is deliberately oblique. Once pressed about the course of interest rates, Greenspan responded: "I was scrupulously open to extraordinary ambiguity on that very subject."

Keeping options open is wise. "Events could easily intervene and change what the right policy is," Cecchetti.

It is a delicate dance.

Openness is important, Poole said, "but is hard to accomplish because miscommunication is so easy."

Some Fed watchers have suggested the committee conduct its deliberations on interest rate policy in public, possibly televised on C-SPAN, rather than in private, as is now the case.

But Greenspan, Poole and other Fed policy-makers have suggested that such openness probably would curtail a free-flowing discussion, possibly send confusing signals and roil financial markets.

"Making effective monetary policy is no Sunday drive in the park," Bernanke said.