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Wednesday, 4 January 2012

Some good news for the New Year! Fed to publish interest rate forecasts.

The US Federal Reserve has announced that it will in future publish its own forecasts for interest rates. (The FT report is here.) Among central banks, the pioneering Reserve Bank of New Zealand has published such forecasts for many years, and they were recently joined by the central banks of Sweden and Norway. However most central banks do not.
                Why is this good news? As any good undergraduate economics student will know, many important economic decisions depend not only on today’s interest rate, but also interest rates in the future. Indeed longer term interest rates are in effect a forecast of future short term interest rates. So when a central bank changes short term interest rates, they are only giving the public a part of the information they need. If interest rates are changed, everyone wants to know how long this change will last.
                Central banks often present forecasts for some key macroeconomic variables, such as inflation. They nearly all use forecasts in arriving at their interest rate decisions. These forecasts, by necessity, will contain some assumption about the path of future interest rates. It therefore seems sensible for the central bank to let people know what assumptions it is making in deriving its forecasts. However most central banks have been very reluctant to do this. There are a number of rather silly arguments that have been used to justify this reluctance, but the one that keeps being mentioned is that the public will mistake conditional forecasts for policy commitments. I always thought this insulted the public’s intelligence.
                On the other side, there is a compelling argument for publishing these forecasts. It has the potential to enhance the credibility of central banks. In technical terms this is to do with commitment under time inconsistency. It can perhaps best be explained by a topical example. A number of economists, and particularly the great Michael Woodford, have suggested that one way to reduce the impact of the liquidity trap (the fact that short term interest rates cannot go below zero) is for central banks to announce that once the recovery is underway, they will allow inflation to rise above target for some limited period. Let us call this the ‘excess future inflation policy’. This will mean that interest rates would stay low for longer. The excess inflation policy has an obvious future cost, but the benefit is that it keeps today's long term interest rates lower (because expected future short rates are lower), and it raises expectations about future inflation, which in turn reduces current short term real interest rates. As a result, the recovery should come sooner. (A variant on this idea is to have a nominal income target extrapolated from pre-recession levels: see here for example.)
                Now whether this is a good idea or not, it suffers from a serious implementation problem. Let us suppose it is announced, and that it works. The recovery is quicker as a result. Inflation then begins to rise above target. Now it is tempting for the central bank to reason as follows. The benefits of the excess future inflation policy have been achieved, but the costs are still to come (i.e. excess inflation). Why not change our minds, and say we will not after all allow inflation above target. We get the best of both worlds. Let us call this the temptation to renege on past commitments. Unfortunately smart agents would anticipate that the central bank will give in to the temptation, and so will not believe the excess future inflation policy will ever be implemented. If it is not believed, the benefits will not happen. So to work, the central bank has to have enough commitment credibility so that the public are sure it will not succumb to the temptation to renege.
                If this is too technical, think of a parent who offers sweets to induce good behaviour from a child. Even if the child does behave well, the parent does not give the reward, because sweets are bad for the child. If that happened, the child will no longer believe the parent’s promises. The parent will have lost an important tool to encourage good behaviour. The parent would be better off in the long run keeping their credibility for commitment by giving the child the reward.
                But how does a central bank get a reputation for commitment? Publishing interest rate forecasts could be a very useful tool. This is because a central bank that was avoiding the temptation to renege would follow its own interest rate predictions if no new information arose. More generally, by checking new information against how interest rate decisions changed compared to earlier forecasts, we could try and judge whether the bank was avoided the temptation to renege. But if the central bank does not publish its interest rate forecast, we have no idea whether it has changed its mind or not.
                It is partly for this reason that I have argued (see here, para 105 ) that the Bank of England should publish its own interest rate projections, at least when it makes interest rate changes. (At present its forecast is based on market expectations, which may or may not be what the Bank itself thinks it will do.) Up until now it has brushed such ideas aside. Now that the Fed will be publishing such forecasts, it will be interesting to see if the Bank decides, or is persuaded, to do the same. 

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