Q+A: Why the Fed is publishing interest rate forecasts

WASHINGTON (Reuters) - The Federal Reserve will begin this month to publish policymakers' forecasts for interest rates, including when interest rates, which are currently near zero, will rise.

The move, announced on Tuesday, could give the sluggish economic recovery a bit more lift by better aligning bets in financial markets with the consensus view at the central bank.

It is also the latest step taken under Chairman Ben Bernanke to provide more clarity about the workings of the central bank, which has historically been shrouded in mystery, often deliberately so.

Following is a Q&A about the decision to issue the forecasts:

Q: Why did the Fed make the move, and why now?

A: The central bank cut its conventional tool for speeding up or slowing down economic growth -- the fed funds interest rate -- to near zero three years ago. But that wasn't enough to pull the economy out of a harsh recession.

Bernanke has since turned to a series of unconventional measures to spur economic growth.

The first approach was a massive expansion of the Fed's balance sheet by buying $2.3 trillion in bonds to drive down borrowing costs further. That process came under withering criticism within the United States and internationally for risking inflation and weakening the dollar.

While the Fed has continued to tinker with its balance sheet, replacing maturing securities with longer-dated bonds, its next policy move has been to give investors and the public more clarity about the thinking of its top officials.

The decision to publish interest rate forecasts won't commit the Fed to providing more easy money. But in practice, it could demonstrate that most policymakers don't expect the first rate hike until farther into the future than was previously thought.

It will also help the Fed out of the bind it created in August when it replaced a vague pledge to hold rates at ultra-low levels for "an extended period" with the more specific vow to hold them there until at least mid-2013. That step was aimed at reassuring markets that the Fed wouldn't turn on a dime and start to raise interest rates if economic data pointed to an improved outlook over a few months.

However as mid-2013 draws nearer, Fed officials wondered whether they would have to push the date further out.

Many analysts believe the forecasts will make clear that the majority of policymakers don't expect the first rate hike to come until 2014 at the earliest.

Bernanke, who has made greater transparency a hallmark of his tenure, has put colleagues in charge of recommending improvements to policy clarity. Further changes, such as publishing explicit inflation targets, may be in the offing.

Q: How will the new forecasts work?

A: Beginning at its January 24-25 meeting, the Fed will issue information about policymakers' projections for the appropriate level of the fed funds rate in the fourth quarter of the current year and the next few calendar years.

The Fed will also report officials' projections for the likely timing of the first increase in the fed funds rate.

In its current forecasts for growth, employment and inflation, the Fed issues a table showing the full range of forecasts as well as a "central tendency" that eliminates the highest and lowest projections. The interest rate projections may follow a similar approach.

The Fed will also describe key factors underlying policymakers' policy projections as their expectations regarding the size of the Fed's balance sheet.

Q: What is the benefit of making interest rate projections?

A: Some economists argue that giving conditional signals about the future course of monetary policy can produce better outcomes than setting interest rates from meeting to meeting.

Some at the Fed also believe that providing rate path projections over the coming years will be especially helpful with rates near zero because the central bank will be able to raise the cost of borrowing more gradually than if it continues to announce policy rates one meeting at a time.

Q: What are the risks?

A: One concern the some central banks have had with publishing rate path projections is that they could send confusing signals to investors. For example, they could be viewed as a firm commitment rather than an expectation which is subject to change as conditions evolve.

The head of the Bank of England, Mervyn King, has been firmly against forecasts for interest rates, arguing last year that it is too open to misinterpretation.

Fed officials have discussed the potential risks and decided they were manageable.

One potential pitfall is that if the Fed uses its practice of dropping out the three highest and three lowest forecasts to publish a central tendency, it may end up giving greater weight to the views of policymakers who favor tighter policy, said Barclays Capital economist Michael Gapen.

"There is some risk that the central tendency may communicate policy tightening will occur sooner than markets currently expect," Gapen said in a note to clients.

Another risk is that Fed policymakers stick to their projections for longer than might be warranted by changing economic data, said Ian Shepherdson, chief U.S. economist at High Frequency Economics.

"Sometimes, less openness can be more effective, and we wonder whether both Mr Bernanke and investors might come to regret this decision," he said in a note.

Q: Does anyone else have experience doing this?

A: Norway and Sweden publish rate path forecasts. New Zealand issues forecasts for 90-day bills that are seen as a proxy for its policy rate.

(Reporting by Mark Felsenthal. Additional reporting by Mantik Kusjanto in Wellington, Balazs Koranyi in Oslo, and David Milliken in London; Editing by Ramya Venugopal)