Fed Forward Guidance

Mark Thoma points us towards a piece in the WSJ by Michael Woodford and Frederic Mishkin regarding the Federal Reserve’s recent change in communication policy and the significance that the alteration brings. For anyone unaware of the way that the FOMC’s communications strategy has been altered, the Fed recently committed to maintain interest rates at or near 0% so long as unemployment remains above 6.5% and inflation expectations at the 1-2 year horizon are no higher than 2.5%, whereas previous policy announcements had merely stated that federal funds rates of near zero were “likely to be warranted at least through mid-2015.” I think there is often confusion about why “forward guidance” about the future course of nominal policy rates should matter (in particular at the zero lower bound) along with what kind of forward guidance is consistent with optimal monetary policy, so I aim to address both areas here.

As Mishkin and Woodford state;

“A commitment not to raise rates in the future as soon as might have been expected is an obvious way the FOMC can loosen current financial conditions.”

But why should expectations of future interest rates matter for the current stance of monetary policy? Take a look at the below equation taken from a paper by Gauti Eggertsson. If you’re not comfortable with maths don’t be daunted by all the subscripts and variables . The Y_t essentially denotes the growth rate of output in the current period ‘t’, the E_t term denotes current expectations so that the first term on the right denotes current expectations of output growth in some future period ‘T’, but what is of critical importance to our discussion here is what is inside the first circular brackets. The term ‘i_s – π_(s+1)’ is the (expectation) of the real interest rate in some future period ‘s’, with the i’s denoting the nominal policy interest rate and the pi’s representing inflation. Lastly the r^e terms (the last terms in the first bracket) are the `natural rate’ or `efficient’ real rate of interest, which is the real rate of interest required to utilize all available capacity and thus achieve maximum output without leading to higher inflation.

equation 1

We can see that if the Fed were able to alter the nominal policy rate each period so that the real rate of interest were equal to the efficient rate of interest, the term inside the first bracket would be zero (the last circular bracket is related to government spending which we can ignore for the purposes of our discussion here) and output growth would be maximized.

However, the position many central banks currently find themselves in to varying degrees cannot be remedied by simple alteration of the nominal policy rate. Take the Federal Reserve, which has its current policy rate effectively at the zero lower bound and is thus unable to lower it any further, and has fairly low inflation expectations . In our equation above, this is represented by the i’s being set to zero at shorter horizons. Yet from our model, we would expect the efficient rate of interest (from a modelling perspective) to be negative during periods of severe economic contraction. If this efficient rate is less than the real rate of interest the term inside the brackets is positive and we have a sub-optimal outcome. Unfortunately current nominal rates cannot be lowered to compensate this, so we end up in a situation where monetary policy is too tight but we are unable to loosen current monetary policy further. But we can see from the equation that current output growth depends on the entire future path of nominal interest rates, so one way we can loosen current policy is to pledge to keep nominal policy rates at zero for longer than previously expected. If everything else in our equation above remains constant (a simplifying assumption for our discussion) then current output growth must naturally increase.

So what is the difference between good and bad forward guidance? Well there could be many different forms of bad forward guidance, but I want to focus on just one. Let’s take the forward guidance policy that generally characterized that of the Fed before last December when the change was made. Generally, the statements said that the Fed was extending its forecast for how long nominal policy rates should remain at or near zero. Take the statement above that economic conditions meant near zero rates are “likely to be warranted at least through mid-2015.” The problem with these statements is that they don’t tell us whether this means the monetary authority has decided the loosen its own stance, or whether it simply expects economic conditions to be worse than previously expected.

Take our above equation. If markets took such commitments as representing a loosening of policy, the term inside the brackets decreases and current output increases – the desired effect. However if these comments are interpreted as meaning the monetary authority expects economic conditions in the future to be worse than previously expected then either the expected future output term in our equation decreases, or the expectations of future inflation (the π_s) decrease, or both decline. Either way, the extension of near zero interest rates is simply responding to worsening economic conditions and does not constitute a relative loosening of policy. At best, the policy achieves no improvement, at worst it signals to market participants that the monetary authority is losing control of its stabilization mandate by repeatedly undershooting its inflation and/or output stabilization targets.

The new forward guidance, coined by some as the “Evans rule” after Chicago Fed president Charles Evans, whist not perfect nevertheless avoids such confusion by illustrating the criteria the Fed uses to decide on the path of nominal rates, and enables market participants to directly observe how loose policy is and how loose it is likely to remain. Most importantly, it clearly illustrates that the Fed will loosen policy until one of two objectives is achieved – inflation expectations increase to 2.5% or unemployment falls to 6.5%.