How Politics Shapes Federal Reserve Communications.

• Author: Binder, Sarah

When I was at the Federal Reserve, I occasionally observed that monetary policy is 98 percent talk and only two percent action. The ability to shape market expectations of future policy through public statements is one of the most powerful tools the Fed has. The downside for policymakers, of course, is that the cost of sending the wrong message can be high. Presumably, that's why my predecessor Alan Greenspan once told a Senate committee that, as a central banker, he had "learned to mumble with great incoherence."

--Ben S. Bernanke (2015a)

So we made one decision today, and that decision was to lower the federal funds rate by a quarter percentage point. We believe that action is appropriate to promote our objectives, of course. We're going to be highly data-dependent. As always, our decisions are going to depend on the implications of incoming information for the outlook.

--Powell (2019a, 5-6)

What a difference a few years make. Under Ben Bernanke, Janet Yellen, and now Jerome Powell, the Fed has helped to deliver an economy with record low unemployment and near 2 percent inflation, just shy of its self-defined price stability target. But low growth, low inflation, and low interest rates--coupled with challenging policy and political environments--threaten the Fed's capacity to autonomously extend the current, record-long expansion. These developments leave the Fed exposed to damaging attacks from the president and lawmakers, especially if or when the economy sours.

In October 2019, Federal Reserve Board Vice Chairman Richard Clarida reflected on the impact of these headwinds on the Fed's approach to monetary policy and observed:

Looking ahead, monetary policy is not on a preset course, and the [Federal Open Market] Committee wall proceed on a meeting-by-meeting basis to assess the economic outlook as well as the risks to the outlook, and it will act as appropriate to sustain growth, a strong labor market, and a return of inflation to our symmetric 2 percent objective [Clarida 2019a].

His "meeting-by-meeting" remark suggests that the communications tools used by the Fed to set expectations for future monetary policy--transparency and forward guidance--are less effective in this sluggish, decade-long, postcrisis economy. With rates near the effective lower bound, conventional policy tools struggle to meaningfully raise inflation and inflation expectations, a serious breach of half of the Fed's statutory mandate. What's more, recent research reveals the difficulty in understanding the process that generates upside inflation pressure (Yellen 2019). Even the "workhorse" Phillips curve finking unemployment and wages struggles to explain low consumer price inflation. Absent a coherent and effective model to generate higher inflation, communication is harder still.

Most accounts attribute the Fed's policymaking difficulties to the challenging economic environment. But the origins of the Fed's dilemma fie in the realm of politics, not just economics. Congressional demands over the past half-century for ever greater transparency push central bankers to justify their policy intentions to their Capitol Hill bosses. But meeting lawmakers' expectations is difficult, if near impossible, when hyperpartisan politicians and the president send conflicting signals about how the Fed should deploy the tools in its arsenal. What's more, important economic and political relationships have frayed, compounding the Fed's difficulties in communicating its policy plans. Retrenching transparency, however, is rarely an option, snarling the Fed in a communications "trap."

Has the central bank's communication toolkit passed its "sell by date"? If so, why? Or does the current political economy simply require the Fed--assuming it secures political support--to reengineer those tools just a decade after the Fed last honed them in the wake of the financial crisis? In this article, we examine the economic and political roots of the Fed's contemporary focus on communication, a component of standard monetary policymaking in which "open mouth policy" plays a key role in setting public, political, and financial market expectations for future policy. We explore how the breakdown of economic rules and political norms threatens the efficacy of Fed communications, especially affecting adoption of the Fed's inflation target and the implementation of its balance-sheet policy. We conclude by considering the political constraints faced by the Fed as it considers revamping its communications given the institution's tenuous position at the center of a polarized political system.

Economic and Political Roots of Fed Communication

Why does the Fed today care so much about communicating its intentions to markets, businesses, households, and the public? Economists and political scientists proffer different explanations. For students of macroeconomics and financial markets, central bankers were historically remiss to make plain their policy rationale and decisions. At the start of the 20th century, Montagu Norman (governor of the Bank of England between the world wars) best summed up the attitude when he reportedly offered the maxim, "Never explain, never excuse." Decades later, Fed chairman Alan Greenspan (1988) famously remarked:

Since I became a central banker, I have learned to mumble with great incoherence.... I might add that on the issues of foreign exchange and interest rates this evening, if you think what I said was clear and unmistakable, I can assure you you've probably misunderstood me. (1) Up until the mid-1990s, the Federal Reserve offered no postmeeting summary of its interest rate decision. Instead, market participants had to infer a policy change from postmeeting open market operations. For decades, central bankers reasoned that transparency made policy less, not more, effective: opacity limited markets from overreacting to the details of Fed decisions and protected the Fed's discretion to change policy in light of economic developments (Yellen 2013).

Since Greenspan's tenure at the Fed, of course, there has been a "revolution" (Yellen 2013) in central bankers' attitudes toward transparency. Economists credit macroeconomic theory for providing a rationale to bolster Fed communications with businesses, markets, and the public. Especially when interest rates are close to zero, central bankers believe they can influence longer-term rates by shaping public expectations about the course of monetary policy. As Bernanke (2002) explains, if investors, businesses, and the public expect rates to be held low into the future, economic decisions can capitalize on that guidance and lower longer-term rates--thus stimulating demand and growth. As always, but especially with rates near the effective lower bound, the Fed's influence on the economy depends directly on its ability to shape expectations about the future. And clear guidance about future policy decisions helps that effort. As Yellen (2013) describes the revolution, the Fed "journeyed from 'never explain' to a point where sometimes the explanation is the policy." Or as Bernanke (2015a) put it, monetary policy is "98 percent talk and two percent action."

Focusing exclusively on the economic origins of Fed communication, however, misses the equally important political roots of and motivation for heightened Fed transparency. Communications are a critical part of central bankers' efforts to meet legislators' demands for greater transparency. Lawmakers value transparency for two reasons. First, transparency offers a political mechanism for members of Congress to hold the central bank accountable for its performance in meeting the mandates cemented in the 1977 Federal Reserve Reform Act: maintaining low and stable prices and maximum sustainable employment. Second, transparency empowers politicians to blame the Fed when things go wrong. A recurring, countercyclical political dynamic drives lawmakers to impose new transparency demands on the Fed (Binder and Spindel 2017). In the wake of economic downturns when lawmakers blame the Fed for the economy's poor performance, Congress often reopens the Federal Reserve Act to impose new requirements on the Fed, challenging central bankers to explain their policy decisions, how they are using their tools, and their process for making policy. The more Congress understands central bankers' policy choices and projections, the easier it is to blame them when the economy sours. Of course, the same dynamic holds for the executive branch: The more the president knows about the future path of monetary policy, the easier it is to demand selfserving policy choices or to blame the Fed when (or if) things go south. In short, words and legislative/presidential pressure for greater transparency are rarely motivated by optimal economics.

Believers in central bank independence will question whether congressional demands for transparency shape Fed policy choices and tools. But the political roots of Fed transparency have the potential to constrain monetary policymakers. To be sure, institutionally the Fed is insulated from the rest of the government. Its funds come not from Congress but from its own operations, and Fed governors have extraordinarily long terms. But from inception to its current role as the most important economic policymaker in the world, the Fed faces pressures not only from lawmakers but also from presidents, bankers and the banks, the public, and global markets. Fed officials inevitably need to balance political pressures (and motives) against what they view as optimal monetary policy. Why? Because the threat of legislative action affecting the Fed--whether to impose new responsibilities or clip the Fed's wings and tools--can discipline the Fed to heed both formal and informal congressional demands. The Fed can rarely risk getting out of step with the public or lawmakers, because Congress can revise the Federal Reserve Act to change the Fed's mandate...