In an attempt to deal with the fallout of the financial crisis, the Federal Reserve innovated a number of nonconventional monetary policy tools that included quantitative easing, interest on reserves, and so-called “forward guidance.” Forward guidance is a component of central bank communications and transparency policies through which the FOMC tries to indicate the likely path of future policy moves. The underlying theory was given prominence by Professors Michael Woodford, Lars Svennson, Steven Cecchetti and other well-known monetary economists in the late 90s and early 2000s in their discussions of how to conduct policy under a zero-bound policy constraint on a target interest rate.
The theory argues that central bank transparency, and in particular forward guidance, can increase welfare and the effectiveness of interest rate policy by telling market participants what the future path of the policy rate will be. According to the expectations hypothesis, the channel works something like this: policy movements in the short-term interest rate will be transmitted more effectively over the term structure if market participants have the same set of information and beliefs as policymakers do, and if policymakers communicate the future path of short-term rates, credibly commit to it, and maintain that path.
The theory is not without its critics. In particular, when the assumptions that markets and policymakers have common information and share the same beliefs do not hold, transparency may not increase the effectiveness of monetary policy. In fact, it may actually drive expectations away from interest-rate fundamentals instead. There is also the concern that, because of its desire to maintain its credibility, the central bank may not adjust its policy quickly enough as economic conditions improve. Recent empirical work by Federal Reserve Bank of St. Louis economists provides at best weak evidence that forward guidance provided by several central banks, including the Federal Reserve, has increased the predictability of future short-term yields and finds no evidence that it enhanced the predictability of long-term yields, which was the claim of proponents of the theory.
The Fed began providing forward guidance in 2008 and offers the following explanation:
“Through “forward guidance,” the Federal Open Market Committee provides an indication to households, businesses, and investors about the stance of monetary policy expected to prevail in the future. By providing information about how long the Committee expects to keep the target for the federal funds rate exceptionally low, the forward guidance language can put downward pressure on longer-term interest rates and thereby lower the cost of credit for households and businesses, and also help improve broader financial conditions.” (http://www.federalreserve.gov/faqs/money_19277.htm)
Against the theoretical background suggesting the benefits of forward guidance, the FOMC has clearly struggled with its implementation, revising both the type of guidance and extending the time frame over which guidance would apply several times. The following is a timeline of the evolution of the FOMC’s forward guidance:
December 2008
The FOMC established a 0-25 basis-point range for the federal funds rate and offered the accompanying guidance and time frame:
“...(T)he Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time.”
March 2009
The FOMC modified and, by inference, extended the time period over which policy would remain accommodative:
“The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and anticipates that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”
August 2011
Following an unscheduled meeting, the FOMC modified the time frame by providing an estimate date through which accommodation would be maintained:
“[The] Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent. The Committee currently anticipates that economic conditions – including low rates of resource utilization and a subdued outlook for inflation over the medium run – are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.”
January 2012
Four months after indicating policy would be accommodative, the Committee extended the expected time period through late 2014:
“[T]he Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions – including low rates of resource utilization and a subdued outlook for inflation over the medium run – are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.”
September 2012
The Committee once again extended the date-based guidance through mid-2015, indicating that policy would remain accommodative for a considerable time after the economy improved:
“To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.”
December 2012
Two meetings later the FOMC kept the “considerable time” language but abandoned the time-frame guidance and switched to keeping policy accommodative until employment and inflation objectives are achieved:
“To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.”
The Committee went on to state that it viewed the employment and inflation thresholds as consistent with the previous date-based guidance, and also sought to make it clear that these were not triggers for action but simply thresholds that would generate a more in-depth discussion of policy accommodation.
March 2014
The Committee abandoned a specific threshold for the unemployment rate and substituted a vague “maximum employment objective” but kept the “considerable time” language:
“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress – both realized and expected – toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.”
September 2014
The Committee kept the March language, although President Plosser dissented. He objected to the “considerable time” language because it was time- rather than data-dependent.
In the press conference following the meeting, Chair Yellen went to great lengths to indicate that future policy moves were not date-based but were instead data-contingent. In effect, she repudiated the “considerable time” language in the statement, validating President Plosser’s concern and effectively adopting his approach. The result is effectively to eviscerate meaningful forward guidance, since we now don’t know how data-dependent the Committee’s views will be. Moreover, the statement indicates that even after the Committee’s employment and inflation objectives are met, “…economic conditions may, for some time, warrant keeping the target federal funds rate below levels the Committee views as normal in the longer run.”
Since the guidance continually changed as the FOMC’s expectations for employment growth, and unemployment failed to materialize, markets now find themselves no better off than before the whole experiment with forward guidance began. From the Committee’s perspective, it became obvious that maintaining fixed forward guidance made little sense in the face of changing economic conditions. Altering that guidance, however, entailed a cost: it meant that markets could not learn whether the FOMC’s commitments were credible, and it cast doubt on whether the Committee would deliver as promised. All that participants know now is that policy is contingent upon incoming data, and the Committee will rely upon discretion when deciding when to reduce policy accommodation.
What the protracted and fateful evolution of the Committee’s forward guidance experience suggests is that there is an inherent conflict between the need to ensure credible forward guidance to markets and the need and desire of policymakers to adapt policy to shocks and unanticipated developments in a dynamic economy. The need for timely flexibility and data-dependent discretion would make the Committee’s lockstep adherence to an obsolete forward guidance policy unwise. In effect, what we have seen is the rational abandonment of forward guidance as a useful policy tool in favor of discretion.
Market participants may or may not realize that discretion is now the order of the day. Those who grasp this shift will now parse more finely than ever the speeches and interviews of FOMC members for clues as to their thinking about the likely path for policy. It will be interesting to see whether the FOMC’s new communications taskforce addresses the forward guidance issue head on or whether it devises instead a strategy that pretends that forward guidance is still in play. Nevertheless, for those rational policymakers who value discretion, forward guidance is dead.