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Monetary policy is evidently at a turning point: Fed officials have been clearly telegraphing rate increases, and the minutes of the December FOMC meeting clearly signal a shift. But uncertainty is high: uncertainty about the effects of rate rises, about inflation, about the course of the pandemic. The signal-to-noise ratio of economic commentary is low, and anyway we probably won't be able to tell signal from noise until after the fact.
Into this morass, this week the Fed's New York branch put out a series of blog posts outlining the central bank's monetary policy implementation framework. The posts are somewhat perplexing. On the one hand, they say not a word about inflation, the reason for the pivot, focusing instead only on how the Fed achieves control over short-term rates. On the other hand, to those who watch the money markets closely, the posts seem to describe an alternate reality, with undue focus on a Fed Funds rate that no longer serves the same purpose it once did.
Let me try, cautiously, to interpret this signal without adding too much noise.
Communication in monetary theory
A central bank can affect money markets in a way that no other institution can. By doing so, it can exert an influence on the payment flows that animate production, employment and exchange. Trillions of dollars flow every day through the Fed's accounts. There are reasons to think that an influence on such flows can be used to affect prices and employment. But it's a tricky job, and the effects can be unpredictable. It also creates winners and losers (borrowers vs. lenders, present vs. future), so it is politically sensitive.
It's hard to argue that the Fed caused the current wave of inflation, but it will certainly be held responsible if it doesn't get prices under control. So the central bank is getting ready to push quite hard on short-term financial markets as a way to try to slow price growth. There will certainly be immediate effects in the money markets, and intervention will probably continue until the effects are felt also at the macroeconomic scale. There is a lot of uncertainty about the mechanisms connecting one to the other. It is less and less plausible that the process will be smooth.
The central bank can move short-term interest rates directly and, usually, precisely. But monetary policy's effects on aggregate measures, like the price level, might depend on the beliefs of the public, including beliefs about the effects of monetary policy. So, to engender belief, the Fed tries quite hard to communicate in a believable way. It talks about what it is thinking about doing, what it is planning to do, what it is doing, what it has done, and what it did.
In the December 2021 meeting, for example, the FOMC hurriedly kicked off a policy normalization process. First step: review of the last normalization process. This is a communication style that is in general pretty boring, but very systematic. There are no abrupt changes, even down to the choice of words that is used.
A reason to believe
All this is to say that the Fed is currently engaged in a complex act of communication on all fronts: meeting minutes, speeches, testimony, you name it. They need to get everyone focused on a single path forward for rates and prices. In that context, what looks like a series of wonkish and technical blog posts is a piece in the communications puzzle as much as it is objective research. It supports the idea that the Fed can precisely fix a short-term interest rate in order to imprecisely (but successfully) target changes in the price level. That idea may be correct or incorrect, but it is more likely to be correct if people believe it.
Or to put it another way, the question is not what is true, but rather what is believed.
Monetary policy communication
Dream a little dream of me :)