How Will Less Fed Transparency Affect Markets and the Economy?

Allison Nathan (0:05)

New Federal Reserve Chairman, Kevin Warsh is steering the Fed into a less transparent era, with shorter post-meeting statements, less forward guidance and a more limited role for projections. This marks a meaningful break from the transparency revolution that's defined at central banking over the last quarter century. So what might a less transparent Fed mean for markets and the economy? I'm Alison Nathan, and this is Goldman Sachs Exchanges.

Each month, I speak with investors, policymakers, and academics about the most pressing market moving issues for our top of my report from Goldman Sachs Research. For our latest edition, I spoke with former Fed Governors Donald Kohn and Stephen Miran, as well as Jan Hatzius, Goldman Sachs' Chief Economist and Head of Goldman Sachs Research. I started by asking Jan if the shift toward a less transparent Fed is a positive or negative development.

Jan Hatzius (1:00)

I do think that the transparency revolution in central banking over the last 40 years or so has been a good thing.

If you provide significant information about your reaction function as a central bank, you say, if we get this kind of data, then this is what we will want to do about it. Then financial markets can anticipate what is going to happen from a policy perspective. Your meeting is not until four weeks later or six weeks later, but you get surprising information. It gets incorporated in financial conditions. And then you basically have to decide whether to ratify that. And if markets have good information about what your reaction function is, what your objectives are, what you think the tools achieve, then you'll see faster monetary policy transmission in a way that you can always not ratify. That's always an option. And I think that's a great framework. And I think it's worked extremely well over the last several decades. So I think unwinding transparency about the reaction function, in my opinion, would be bad. There's a separate question about forward guidance, about the path of the policy rate. And I think there the answer is more nuanced. Economists sometimes refer to so-called Odyssean forward guidance. Odysseus tied himself to the mast. And you basically commit yourself. You say, here's what we're going to want to do, even if the data at some point down the road tell us that maybe we should do something else.

That doesn't make any sense under normal circumstances. It can make sense when you have the effective lower bound for shorter menstrual sprains, but even then it's a debate. Then there's so-called Delphic forward guidance. The Oracle of Delphi, the policy outlook is conditional on the economic data that comes in. That's more defensible, I think, even in normal times.

The counterargument is market participants are going to think that what is actually supposed to be Delphic is Odysseum, but I actually like the way the Fed does this with the dot plot. The dot plot is not, in my opinion, strong forward guidance, not even strong Delphic forward guidance. It's just the views of the different FOMC participants that are implied by their economic expectations and I do think most sophisticated observers understand the conditional nature of the dots and I do think they view it mostly as information about where you would be if the economy evolves in the way that the Fed expects, which is also incorporated in the summary of economic projections and they understand that if you get a move away from that, that the policy would also change. So I view this more as additional information about the reaction function.

Allison Nathan (4:04)

Don Kohn agrees that it's important for the Fed to provide clarity on its reaction function, but he sympathizes with some of Warsh's views about forward guidance and the dot plot.

Donald Kohn (4:14)

One thing that I've pointed to over a number of years now is the focus on the median forecast in the SEP, the economic projections of the FOMC participants. That is a very weak indication of where the committee is when just one person shifting can shift that median. And I've seen that happen every once in a while, one or two people shifting and then the market reacts. So it's crazy to focus on that median. I think more serious is the forward guidance issues. So here I have a little sympathy with Chairman Warsh. His concern is the forward guidance. What are we going to do next is both constraining the committee and constraining the market reaction to incoming information. And I think a good example where it constrained the committee with adverse consequences was coming out of COVID.

So the forward guidance was we're going to hold rates at zero until we're at full employment, almost no matter what the inflation rate is. And I think just looking at the structure of that forward guidance, in what world is it okay to have at the highest a real rate of minus 2% at full employment? So I think that forward guidance was not well conceived. And I think it did constrain the committee, which is not to say that some guidance isn't helpful and at the zero lower bound may be necessary. When you get away from the zero lower bound, I think there's less need for guidance and you can always adjust policy. So I think forward guidance becomes much less helpful when you get away from the zero lower bound. And I would be a reluctant user. Having said that, I think the problem right now with Chairman Warsh is not giving forward guidance. That's fine. Shouldn't be a problem in these circumstances. But he refuses to talk about how the committee sees the economy evolving. And I think that's not helpful. I think explaining how the committee is thinking about the economy, what it's worried about, is part of helping the markets be stabilizing rather than destabilizing. And it's part of accountability. He's got a communications task force. I hope that one of the messages they give him is you need a narrative, you need a story, you need to be able to say what's going on in part. Because if you're not saying what's going on, how do you know when things aren't happening the way you thought they were going to happen? So you're holding yourself accountable.