Tim Duy's Fed Watch: Neutral or Not?

Tim follows up on his most recent Fed Watch. Apparently, there was a communication problem:

Brad DeLong hits on an important point after reading my last piece:

The reasoning is that a shift to a "neutral bias" will be interpreted as a statement that the Fed is more likely to cut than raise rates in the near future, and that a Fed that is neutral should not say that it is neutral. I think that this is a mistake. Since the Fed is (I think) neutral at the moment, it should say that it is neutral.

At the moment, all of us believe the Fed is effectively neutral. Expectations are for steady policy for the next three meetings. In fact, we saw virtually no shift in expectations even in the wake of the April jobs report. So why not just say this? Fed Chairman Ben Bernanke would reportedly like to do exactly as Brad suggests. From the March 27 Greg Ip piece that foreshadowed Bernanke’s Congressional testimony two days later:

The new statement reflects a Fed on hold. It contains no explicit reference to the direction of rates, saying only that "future policy adjustments will depend" on growth and inflation, but reiterates enough inflation concern to indicate lower rates aren't on the table.

Communicating the nuances of this stance will be a challenge for the Fed. Better communication with the public has been an important goal for Chairman Ben Bernanke, who testifies to Congress tomorrow on the outlook for the economy. Mr. Bernanke feels the Fed's words should mean what they say, and not be shaded to manage market expectations, as was sometimes the case under his predecessor, Alan Greenspan.

However, in the wake of last week's meeting, interpretations of the Fed's policy statement varied widely. In the immediate aftermath, investors assumed the Fed intended to signal that rate cuts were more likely, and drove down bond yields. The following day, markets reconsidered and concluded that the Fed still had an inclination to raise rates, and bond yields shot up again.

Sometimes it is not so easy to say exactly what you mean. Moreover, the implication in the article is that Fed officials reiterate the inflation concern at least partially to manage expectations, in this case to avoid the interpretation that rates cuts are on the horizon. This sounds like exactly the false inflation concern that Brad warns against.

Suppose the Fed were to drop its inflation concern, would that shift the current expectations that the Fed is on hold for the next three meetings? Would the Fed want to shift expectations? I think these are important questions for policymakers. The most recent Fed speak by San Francisco Fed President Janet Yellen and Governor Frederick Mishkin both appear to be consistent with the views expressed in the last statement – that there are risks to both the inflation and growth forecasts, they are comfortable with the current policy stance, and they remain wary of inflation. And incoming data does not appear to be sufficient to sway the Fed into a policy change one way or the other (see also John Berry at Bloomberg). Consequently, most Fed watchers are expecting a continuation of the current language. This includes the warning on inflation, which is dubbed the inflation bias. Without the language, the implication is that policy has changed.

But perhaps we are using the terms “inflation bias” or “inflation concern” too loosely, when what we more accurately mean is that the Fed will want to communicate that policy effectively remains on hold in the near term, ready to respond to changing economic conditions whatever they may be. A properly nuanced statement could accomplish this without engendering expectations that a rate cut this summer is a sure thing. Are we ready to read it?