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The Fed’s New Forward Guidance

Like any good corporate chief executive, later this month, 17 Federal Reserve officials will start to give their own forecasts for short-term interest rates, a bit of forward guidance on how long the central bank's zero to 0.25% rate will stay in place, in the hopes that all this will spur investment and spending.

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Pre-announcing the direction of the federal funds rate is an historic move for the bond markets, investors and borrowers. The fed funds futures market now bets a rate hike could come in the summer of 2014, not 2013 as the Fed previously indicated.  

Giving Fed officials more power to forecast short term rates could give the central bank even more power over pushing bond yields in the direction the central bank wants – in turn making it easier to manage the economic recovery, the “fatal conceit” economist Friedrich Hayek warned about. Already, the Fed gives forecasts on economic growth, inflation and joblessness.

When will the Fed tighten? When inflation is high or the jobless rate low, or somehow, both? See below for how this tug of war on when it should hike rates under its “dual mandate” has historically put the Fed in a bind.

Also, 17 different forecasts from 17 different Fed officials -- five governors and 12 regional presidents -- could mean a cacophony of voices attempting to calm markets that have seen record volatility, previously unheard of triple-digit swings now commonplace.

“The projections for the federal funds rate will come from..members of the Washington-based Board of Governors and the presidents of the regional Reserve Banks,” the Federal Reserve said in an email to FOX Business. “So, it will be a collection of individual projections from these officials -- not a single projection.”

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Yes, the 17 forecasts could also give ventilation to the Fed hawks like Richard Fisher or James Bullard who disagree with elements of the U.S. central bank’s historic monetary intervention.

However, it isn’t just that the new move puts Fed officials at risk of flip flopping if they change their minds on the Fed’s discretionary monetary policies.

While the rate forecasts and more frequent press conferences are ostensibly about “transparency,” all of this is more about the Fed now actively managing expectations. And averting the blame for triggering future economic crises with sudden rate hikes, criticism the Fed faced notably in the U.S. in the late ‘70s and early ‘80s, as well as the Mexican debt crisis of 1994.

The Fed's new forecasts come at a time when the Fed’s dual mandate of price stability and maximum employment (essentially a political function) has roped it into political controversies about massive government spending that has added the equivalent of two Russias to the federal balance sheet since 2008.

Historically, the  fed funds rate is the chief lever of monetary policy, although the central bank has also expanded its balance sheet to $2.9 trillion -- about the size of Germany, and a record 19% of U.S. GDP -- to attempt to reflate assets, by buying bonds to drive down bond prices, and thus borrowing rates.

That policy is called, in typical government obscurantist jargon, “quantitative easing,” or QE. Translation: The Fed, with the touch of a computer button, increases reserve balances at the banks, and also buys Treasuries off of bank balance sheets. Market analysts also say this latest policy shift on new rate forecasts means the Fed could be laying the ground work for setting sail QE3 or even QE4 this year.

“Putting the fiat in fiat money,” as Rep. Paul Ryan acerbically notes -- money conjured up out of thin air and backed by the thin promises of bureaucrats who, by government fiat, declare their policies are trustworthy and sound.

It also includes a policy whereby Fed officials still stare morosely at a balance sheet that is really a storage facility for a mountain of rotten assets, like hotel or motel chains or strip malls, picked up in its bail out of Bear Stearns and AIG. Private market debt has truly gone sovereign.

Historical evidence is mixed on whether quantitative easing helped Japan, whose economy is trapped in a decades-long period of slow growth and deflation due to its earlier credit excesses.

Such Fed rescues, and its creation of huge sums of bank reserves as well as Treasury purchases also undermine criticisms of China by the Administration and Congress, whereby U.S. officials demand that China must stop gunning its printing presses to lower the value of its yuan and cheapen its exports. Attacks that come after U.S. Treasury Secretary Timothy Geithner has promised to double U.S. exports by 2015, hopefully via a cheaper dollar.

The Fed’s low rates have also been blamed for pushing savers with low bank deposit rates into chasing yields in riskier investments, notably seniors on fixed income.

Savers have been plowing into emerging markets, into commodities, into gold, silver, even Nebraska or Iowa farmland, to hedge against the decline in the value of dollar assets. It’s a bet, too, on the expectation that two billion to three billion people around the world are expected to join the middle class in the next decade or so, pushing food and energy prices higher. When will this low-rate environment end?

Not known for now is the Fed’s exit strategy out of its historic moves to rescue the U.S. economy, or the effect of its future tightening on bank lending,  borrowing rates, or the U.S. economy.

The exit strategy is key. When the Federal Reserve has hiked rates in the past, it’s been accused of triggering recessions and crises in emerging markets.

That could be another reason why Fed chairman Ben Bernanke is relying on more frequent press conferences, which is what his counterparts have been doing for some time now at the European Central Bank, the Bank of England, and the Bank of Japan. As are rate forecasts common in Norway, Sweden and New Zealand.

The Fed’s exit strategy out of its historically loose monetary policies, whenever it comes, could look like this: It may first drop the “low rates for an extended period” language, then shrink its balance sheet by selling its stash of U.S. bonds to pull liquidity out of the banking system. It could also simply let its hoard of U.S. bonds mature.  

And the Fed could also zero out the rate it pays banks to park their excess cash on reserve with the central bank, blamed for the lack of credit. Then it could hike the fed funds rate in quarter percentage point increments, more or less.

Remember, monetary policy operates with a six month to a one year lag, so the Fed has been criticized after the fact for all sorts of crises.

The Fed was accused of triggering a recession after it hiked rates from 6.5% in 1977 and then by 1979 to 13.8% to deal with an inflation crisis. From there it hiked rates to as high as 19% by 1981 to squeeze out inflationary excesses. Rates began to drop below 10% in 1982.  

Worth noting is this move, that the Fed had already redefined inflation as “core inflation” in the ‘70s, knocking out food and energy prices as it embarked on an expansionary monetary policy to help pay for the cost of the Vietnam war, among other things.

In the early ‘90s, seeing core inflation dropping to below 1.5% from 2.5%, the Fed then cut rates from 1992 to 1993 to around 3%, triggering a steep yield curve.

But then as inflation heated up, the U.S. central bank let rates rise to more than 6% in 1995.

But that threw the bond market into turmoil, mortgage-backed securities began selling off, and the Fed’s rate hikes were blamed for triggering Mexico’s 1994 financial crisis, brought on by a reckless government that blew out its debt, among other things.

And then the Fed was attacked for fostering bubbles. The central bank did finally raise interest rates in the summer of 1999. But by the end of 1999, the Nasdaq Composite index quintupled, from 750 to 3700. The dotcom bubble was upon us.

What's important here is this. The Fed has a dual mandate set down by Congress in 1978. It did not have any mandate when the U.S. government first launched the central bank in 1913 to be the lender of last resort, giving it plenipotentiary credit powers as a bank panic gripped Wall Street.

After the Great Depression and World War II, in 1946 the U.S. Congress dictated that the Fed’s new mandate was “to promote maximum employment, production and purchasing power.”

In 1978, the U.S. Congress gave the Fed this mandate, "to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates." The latter two are  the same, in other words, to protect the U.S. dollar as a store of value. Today the Fed's unofficial third mandate is reflating our homes, the stock market, and 401(k)s.

It’s an understatement to say that maintaining a dual mandate of price stability and promoting full employment has proven devilishly hard for the Fed.

Say the Fed only had a “full employment” mandate. Joblessness dropped below 5% in 1997. Should it have aggressively raised rates in that year? Would doing so have stopped the coming dotcom bubble, or an incipient housing bubble?

Even Alan Greenspan, former Fed chair, unwittingly noted this tug of war. In 1997 he said the Fed cut rates between 1990 and 1993 to foster “a satisfactory recovery from the recession of that period” so as to fight joblessness.

But then in whipsaw fashion, the Fed suddenly had to tighten in 1994 and 1995 to prevent inflation. Which is it? 

Later, in July 2003, then Fed governor Bernanke reminded listeners to his speech that an "unwelcome substantial fall in inflation" in the early nineties was the central bank’s justification that the Fed had used to slash the fed-funds rate to 1%. At that time, the Fed was keeping rates microscopically low, to rescue the economy from recession.

Then the Fed waited to slowly raise rates from 1% beginning in 2004 to about 5.25% in the summer of 2006, keeping them there through 2007, when it started to slash again later that year down below 4% as the markets started to fall as the financial crisis set in.

But prior to the Great Recession bursting onto the scene in 2008, inflation was never higher than 2.5%, and the jobless rate was fairly manageable. The rate hikes in 2004 came three years after the jobless rate began to drop from 6.3% to 4.6% by 2005, and then hovered around there. So why raise rates, if you’re sticking to a dual mandate? 

It could be argued that in 2004 Fed had tried to manage rate hikes smoothly, without upsetting the markets. But by then the housing and credit bubble were dangerously ballooning.  

In its defense, Fed defenders say it can’t prick bubbles with rate hikes because it would be akin to smashing an ant with a sledge hammer.

But did the Fed see the bubble? The Fed focuses on core inflation, which excludes not just food and energy but home prices, and instead includes rental costs.

By 2004, home prices were climbing at a rate of almost 10 % a year — more than four times the increase in rents at that time.

The preferred core inflation index would have been over 5% had home prices been included, analysts note. Instead, the reported core inflation rate was just 2.2% because home prices were not included. They still aren't.

Also, can any central banker continue focusing on core inflation when India and China adding two billion to three billion new middle class consumers in the next decade?  

For now, foreign central bankers have criticized the Fed for an incoming wall of money, saying the U.S. central bank’s easing is triggering asset bubbles and inflation in places like Brazil and China. But Mr. Bernanke has made it clear central banks around the world are responsible for the cooling or overheating of their own markets. 

That is, central bankers there can either hike their own interest rates or let their own currencies appreciate, even though they risk slowing down their economies.

To avoid that, countries have instead used capital controls and the like to build a bulwark against the dollar inflow.

For now, all the markets can expect in the way of Fed leadership on a strong U.S. dollar is tough talk about a commitment to price stability.

Which is why it’s worth pointing out this irony Derek Scissors of the conservative Heritage Foundation has noted: “The biggest force undermining the dollar is the US Federal Reserve, and the $$’s biggest defender is the People’s Bank of China,” as it has been backstopping the dollar via its sizable Treasury bond purchases.

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