Washington, September 17--The Federal Reserve concluded that its new policy of talking more clearly about its interest-rate plans had a sizable impact on bond markets last year, helping to avert deflation when the Fed's main interest-rate target approached zero.
The Fed's new study is likely to embolden the central bank to be even more explicit in the future in talking about its interest-rate plans. It may also make the Fed a bit less worried about the risk of deflation and a bit more confident in its current campaign to raise interest rates from last year's deflation-scare lows.
But the study may fuel fears that U.S. interest rates could be driven up if foreign central banks stop buying Treasurys.
The study is by Ben Bernanke, a Fed governor, Vincent Reinhart, the head of monetary affairs for the central bank, and Brian Sack, a former Fed economist now at the forecasting firm Macroeconomic Advisers LLC.
Central banks can combat inflation by raising the overnight interest rate as high as needed, but they cannot cut that rate to less than zero to combat deflation, or generally declining prices. Inflation, excluding food and energy, slid from 2% in late 2002 to about 1% in late 2003, when the economy remained sluggish in the face of Iraq war worries and corporate scandals.
Fed officials worried prices could actually fall, though they thought it unlikely. While they had theoretical alternatives for stimulating the economy once the federal-funds rate -- charged on overnight loans between banks -- approached zero, they didn't know if they would work in real life.
The study found "some grounds for optimism" on the effectiveness of these alternatives. But it also warns that there is still enough uncertainty that the Fed should avoid needing them -- by ensuring that the inflation rate never comes close to zero.
From August to December 2003, when the target for the federal-funds rate was at a 45-year low of 1%, the Fed said it could hold rates low for a "considerable period." The study found that the phrase reduced expectations for short-term rates a year later by more than half a percentage point. It also reduced Treasury bond yields by seven to 20 basis points. A basis point is one-hundredth of a percentage point.
The powerful impact of "policy making by thesaurus," as the study calls it, suggests the Fed will use such communication more in the future.
