When the Fed speaks, why does the world jump?

Fed chief Ben S. Bernanke (left) in 2008, with Randall S. Kroszner, then a governor. "Every word, every syllable . . . gets a great deal of attention," Kroszner says.
Fed chief Ben S. Bernanke (left) in 2008, with Randall S. Kroszner, then a governor. "Every word, every syllable . . . gets a great deal of attention," Kroszner says.
Posted: August 13, 2010

Eight times a year they gather in Washington, the 12 members of the Federal Open Market Committee, and their pronouncements on the state of the U.S. economy are much-awaited and much-studied.

Like the messages from the Oracle at Delphi, or the color of smoke in the election of a pope, they take on an importance that far outstrips their modest appearance - a few paragraphs on one sheet of paper.

That was the case again Tuesday, at 2:15 p.m., when the FOMC declared that the pace of the economic recovery "had slowed in recent months."

That temperate, hardly new assessment created immediate spasms among the world's investors. The U.S. markets rallied after the announcement, but Wednesday began with a wipeout in the Asian and European markets, and then in the United States. By Wednesday's close, the S&P and Nasdaq had tanked about 3 percent. The distress continued Thursday.

Which raises a few questions:

Why did this Fed statement create such whiplash? What is the process that results in these periodic assessments? And is entirely too much attention paid to them?

The FOMC meets every six to eight weeks. The seven governors of the Federal Reserve, chaired by Ben S. Bernanke, and the presidents of the 12 Federal Reserve banks participate in the meeting, but only the governors, the president of the New York Fed, and a rotating group of four bank presidents vote on policy.

They gather in the Eccles Building at 20th Street and Constitution Avenue in Washington. It's a striking, classic yet modern, beaux-arts edifice, and the meeting is held in a regal, high-ceilinged conference room and around a 22-seat, 27-foot, two-ton, mahogany-and-black-granite conference table.

The protocol that results in the statement actually begins a week ahead of time, with a flurry of e-mails among the governors and the Fed bank presidents.

Randall S. Kroszner is a professor at the University of Chicago and was a governor on the Fed board for three years beginning in 2006. The e-mails, he said, produce proposed versions of the statement, with the final draft being hashed out when the group meets in Washington.

The sessions, which last one or two days, are divided into two parts - one part to assess the current situation, the other to consider possible Fed action. Each FOMC member will give a viewpoint on the economy.

Finally, the board tries to settle on a version of the statement.

"Sometimes, it's very clear where the consensus is, and there doesn't have to be much change," Kroszner said. Other times, there is "drafting going on at the meeting" and "robust discussion."

In the end, The Statement, the much-anticipated economic diagnosis, is burnished by a senior staffer. Tuesday's statement was seven paragraphs and was placed on the Fed's website for viewing.

Then came the economic frenzy.

Members on the committee are fully aware that their words will affect the market, Kroszner said.

"Every word, every syllable that the top federal officials say gets a great deal of attention," he said. "That leads people to pick their words very carefully.

"We would try to anticipate what the reactions would be to the statements, but the key in making the decisions was what we thought was best for the economy. It is a circumstance in which every word counts."

The statement signals several sectors of the economy as causes for the slow recovery. But they are ones that have been lagging since the mild recovery began: unemployment, housing values, new home starts, consumer spending, and tight credit.

It was old news creating fresh fears. But why?

"There was nothing earthshaking in that statement, nothing that you would read and say, 'Wow, that came out of left field,' " said Hank Smith, chief investment officer for equity at Haverford Trust Co. in Radnor. "The only thing I can gather is that the market may have been expecting more."

David R. Kotok, chief investment officer at Cumberland Advisors in Vineland and Sarasota, Fla., saw the same statement and took another view.

"I think the market expected the Fed to do nothing, and what the Fed did suggests to market agents that the Fed is more concerned about the weakness of the economy than originally thought," Kotok said.

The Fed said it would spend about $10 billion a month buying Treasury bonds, instead of allowing its balance sheet to shrink. The goal is to maintain the current level of stimulus to the economy at a time when the committee can't drive the key overnight-lending rate between banks any lower.

Is too much weight given to the Fed's statements?

They should be taken seriously, says professor Allan Meltzer, of Carnegie Mellon University, who, in 1973, cofounded the Shadow Open Market Committee to evaluate the FOMC policy choices.

"In the last 25 years," he said, "the market has always responded to the Fed."

But, he said, the Fed's credibility is now being damaged by its constant response to short-term business conditions.

"When the market people say they are worried about the slowing economy, [the Fed] jumps," even though FOMC members know that whatever action they take "won't have an effect for six or nine months from now," Meltzer said.

"They should use their bully pulpit, and they have a big voice," he said, "to announce and follow a long-term strategy."

But, and this is crucial, Tuesday's pronouncement from the pulpit was longer than June 23's pronouncement, said professor Kenneth J. Kopecki, chairman of Temple University's finance department.

"It means something when it is longer," said Kopecki, a former senior Federal Reserve economist.

Several of the paragraphs are exactly the same, "but it's the words that are different that need to be examined in detail, especially the adjectives and adverbs," he said.

"The world is filled with a cacophony of statements. Each of them may be right or each may be wrong," Kopecki said. "But out of this huge cacophony of noise, [the Fed's] is a respected signal. By and large, it's the only game in town that we can say speaks with a lot of intellectual effort behind it. Not to say it's always right. The world is hard to understand."


Contact staff writer Jane M. Von Bergen

at 215-854-2769 or jvonbergen@phillynews.com.

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