A Measured Approach to Accommodating a Change in Fed Communication?

One of the decisions the FOMC will have to make at their meeting on Tuesday is how to communicate future intentions in the press release after the meeting, in the subsequent minutes, and in FedSpeak. At some point the language will have change as rates level off. But what's the best way to communicate that intention? Here's Greg Ip of the WSJ:

Fed Weighs Change to Vocabulary, by Greg Ip, WSJ: As the Federal Reserve prepares for a historic change in leadership, the ... strategy of unusually open communications also faces a crucial transition. At a meeting next week, Fed policy makers will almost certainly raise their short-term interest-rate target to 4.25% from 4% ... They also will weigh the biggest changes in the accompanying explanatory statement since June 2004 ... Since it began to raise rates ... 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...

Fed officials expect to drop or water down their previous language soon. Minutes of the Fed's Nov. 1 meeting ... 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. "...there obviously will come a time when these two phrases are no longer appropriate." ...

Dispensing with forward-looking language ... wouldn't mean the Fed is philosophically less committed to transparency. ... officials have always said the predictability of their rate actions in the past two years reflected unusual economic circumstances. As those circumstances change, the Fed could end up misleading markets if it were to telegraph intentions that it was less certain of... Even without the forward-looking language, the Fed could ... signal its inclinations by labeling either weaker growth or higher inflation as the greater threat to the economy.

Fed officials are weighing two options. The first option is the status quo: Wait until the Fed has stopped raising rates before removing the forward-looking language about "measured" increases. ... The second option is evolution: Replace the current language with less restrictive language that still conveys the likelihood that rates will continue to rise. That process could begin Tuesday, or in January. Adopting this tack before Mr. Bernanke takes office could give him more freedom in plotting monetary policy. ...

[F]or now officials appear undecided. Until recently, they preferred the status quo. The difficulty of getting all 17 policy makers on the Federal Open Market Committee to agree to an incremental change in the statement has biased the group in favor of no change at all until the Fed is finished raising rates. ... More recently, evolutionary change has gained some appeal. ... [M]ost Fed officials agree that a 4.25% funds rate would be in the range of neutral, so calling monetary policy "accommodative" would be increasingly untenable. "Measured" has also become problematic. Though officials agree the rate has to rise further, they aren't sure by how much. Markets currently expect the Fed to either raise the rate to 4.5% on Jan. 31, then stop, or to increase it to 4.75% on March 28 at Mr. Bernanke's first meeting as Fed chairman, and then stop. That closely matches officials' own split views. Recent economic data haven't clarified the Fed's job. Inflation excluding energy prices has been surprisingly benign ... But the overall economy has been growing faster than its long-term trend...

If Fed officials drop the forward-looking language Tuesday they will try to avoid markets interpreting it as signaling a halt to rate increases. Officials say the markets overreacted by interpreting the Nov. 1 minutes as signaling such a halt, and they may be reluctant to risk a similar overreaction ... On the other hand, the release of the minutes may also have primed the markets for a change in the language.

This is a good summary of the issues. One thing I might have emphasized more is the ability of FedSpeak to communicate in ways other than just the press release after FOMC meetings and the subsequent release of the minutes. Because the market pays such close attention to every word uttered by Fed officials, I'm not sure having the language in or not is a critical issue. The Fed retains the ability to signal its intentions in either case. And when the path ahead is sufficiently uncertain, the flexibility the Fed gains from not being bound be the pre-commitment inherent in forward looking language may be valuable. 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.

Update: See William Polley for more.