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The Drawbacks of Forward Guidance

BERLIN – The nomination of Janet Yellen to succeed Ben Bernanke as Chair of the US Federal Reserve comes at one of the riskiest moments in the recent history of the Fed. The Fed’s announcement in May that it might start tapering its long-term asset purchases surprised many central bankers, and triggered a sell-off from markets worldwide. But some of the good news about America’s economy was bad news for financial markets, because investors considered the Fed’s potential policy tightening in response to such news to be more relevant than the news itself.

Then, last month, when the Fed postponed its withdrawal from so-called quantitative easing, markets quickly turned euphoric. Indeed, investors today appear less concerned about the real economic story than about the Fed’s interpretation of it. This underscores an important risk that Yellen must now reckon with as she guides US monetary policy: in the longer run, the dominance of the Fed’s views in the market may cause serious economic harm.