The communication channel

by Jérémie Cohen-Setton and Shahin Vallée on 3rd February 2012

What’s at stake: Over the last year the Federal Reserve has been confronted with growing challenges to meet its dual mandate. In this context, it has taken a number of steps to improve its communication strategy and change its monetary policy framework. At its latest meeting on January 25, the Fed decided essentially three things, (i) it changed the language of its statement to indicate that low rates would likely be justified through at least late 2014. (ii) it said that the Fed had adopted an inflation target of 2% for personal consumption expenditures (PCE), and (iii) it released new information alongside the standard economic projections, which showed the distribution of the committee's views on when rates ought to rise. These changes were evident in the FOMC statement, in its projection for the paths for main macroeconomic indicators and in its agreement on the principles regarding its longer-run goals and monetary policy strategy, which had been agreed to in December but released just now. These changes are far reaching and will have a number of consequences for the US monetary policy.

MP @ the ZLB crash course

Gavyn Davies writes that at a time when the extension of the balance sheet is causing political difficulties for the Fed, and when inflation expectations could become unhinged by the rapid expansion of the monetary base, the chairman was looking for alternative ways of easing monetary conditions without printing more money. Modern macroeconomics suggests that operating on expectations is one of the most powerful tools available to him, though he is using it much more cautiously than many economists would like to see.

Back in August when the Fed provided additional clarity about the path of its short-term rate target in changing the language of its statement, Matt Rognlie – a PhD candidate at MIT whose blog has become widely followed – expressed enthusiasm writing that a decade of macroeconomic research was finally making a difference. By moving from a wishy-washy pseudo-promise to hold interest rates low for “an extended period” (which can mean anything) to a pseudo-promise to hold interest rates “through mid-2013″, the Fed had taken a tremendous step in the right direction. This policy is straight out of Eggertsson and Woodford’s 2003 BPEA piece, the key article for understanding how to conduct monetary policy in a liquidity trap, which formalize within a full-fledge New Keynesian model the insight first articulated by Krugman in his 1998 BPEA piece that the Fed’s commitment needs to be explicit and concrete. Of course, the “extended period” language was absolutely useless for making a commitment as it was deliberately ambiguous and designed to give the Fed as much flexibility as possible going forward. Rognlie notes that, by modifying its communication framework, the Fed is finally the central question of monetary policy today: commitment. Until then, the Fed had relied upon meaningless phraseology or exceedingly indirect signaling mechanisms (QE).

Iván Werming – professor at MIT – shows in an important paper that there is more to optimal monetary policy in a liquidity trap than promoting inflation. Optimal monetary policy – defined as the MP that maximizes the utility of the RA in the model – is engineered not only to promote inflation, but also an output boom. The planning problem features both inflation and the output gap as state variables, so commitment to deliver promises for both inflation and output are generally required. The logic is completely different from Krugman’s case as first presented in his 1998 BPEA paper, which isolated the inflationary motive for monetary easing. There are two things optimal monetary policy accomplishes. First and most obvious, it promotes inflation. This helps mitigate the deflationary spiral during the liquidity trap. Lower deflation, or even inflation, lowers the real rate of interest, which is the true root of the problem in a liquidity trap. Second, due to the non-neutrality of money, it stimulates future output, after the trap. This percolates back in time, increasing output during the trap. Anticipating a boom, consumers lower their saving and increase current consumption, mitigating the negative output gap. In this model the two goals are related, since inflation requires a boom in output. It does so, in part, by committing to holding the nominal interest rate at zero for an extended period of time.

Simon Wren-Lewis – professor at Oxford University – argues in his blog that publishing interest rate forecasts is a very useful tool for a central bank to get a reputation for commitment. By checking new information against how interest rate decisions changed compared to earlier forecasts, we could try and judge whether the bank was avoided the temptation to renege. But if the central bank does not publish its interest rate forecast, we have no idea whether it has changed its mind or not. It has the potential to enhance the credibility of central banks.

Paul Hubert provides evidence on the OFCE blog that the publication of the Fed’s forecasts has persistent effects on private expectations. The author, in particular, shows that the FOMC inflation forecasts, published twice yearly since 1979, have a persistent positive effect on private expectations (as reported in the Survey of Professional Forecasters). Expectations rise by 0.7 percentage point when the Fed increases its forecast by one percentage point. Expectations rise by 0.7 percentage point when the Fed increases its forecast by one percentage point. A likely interpretation is that an increase of 1 percentage point of inflation will occur and that by announcing it, the Fed sends a signal to private agents. They then expect a response from the Fed to counter the increase, and so reduce their expectation of the increase. The Fed’s communication would therefore have succeeded in preventing a 0.3 percentage point increase in future inflation, meaning that the announcement has been effective.

Time horizon of the inflation target

In its statement, the Fed explains the rationale for choosing a long-run time horizon for its inflation target in the following words. “The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation.” As one would expect, they however recognize that monetary policy has no impact on the long-run level of output, which prevents them for directly setting a target on NAIRU.

Lorenzo Bini-Smaghi – former ECB board member – argues that the long run is not a policy-relevant time horizon and therefore be misleading. This time horizon differs from most other central banks in advanced economies, where price stability is targeted over a horizon of two to three years. The reason for focusing on the medium term is that inflation forecasts over a longer period are not very reliable. Price movements 10 years from now will depend on factors that cannot be foreseen today and in any case are hardly affected by today’s policy decisions.

Ryan Avent, Lorenzo Bini-Smaghi, and Brad DeLong argue – in separate pieces – that the Fed's communications efforts to boost the economy run up against its long-term inflation forecast. The link between the inflation forecasts and the policy decision is unclear when the objective of price stability is defined over the longer term. What should market participants derive from a published inflation forecast above the two per cent target in the long run (but not necessarily over the next two years)? If the Fed were to project a long-run inflation rate above 2% then, markets might suppose that monetary tightening lay ahead, whatever the fine print says. In the words of DeLong, QE accompanied by declarations that the central bank has not changed its long-run inflation and price level targets, undermines the jawboning and therefore reduces the effectiveness of the expectations channel. This is one of the tight spots in which the Fed finds itself as it transitions from a framework that wasn't very good at boosting the economy at the ZLB to one that might be.

Fan charts

Henrik Jensen – professor at the University of Copenhagen – makes the interesting point that the Fed has now firmly joined the camp of inflation targeting central banks by not only making its target more explicit but by also providing the classical fan chart for inflation and GDP forecasts made so popular by the Bank of England, the Riksbank or the Norgesbank. However, contrary to these central banks where the probability for the different scenarios are derived from the confidence bands of their own model, the Fed actually uses the forecasts of its FOMC’s members’ own projections. In this sense, dissent is now not only mentioned in the FOMC statement but also quantifiable. Interestingly however, the Fed maintains anonymity but since monetary policy actions are determined by only a subset of the 17 FOMC members, and since the composition of the FOMC vary according to a fixed rotation scheme, if would be helpful to get faces on the dots.

Nominal interest rate path relative to the expected path of its natural rate

Macro Musings thinks that the publication of its expected interest rate path will backfire because what observers really need to know is where the expected path of the federal funds will be relative to the expected path of the natural (or equilibrium) federal funds rate. The FOMC lowering its expected path of the target federal funds rate need not only be interpreted as monetary easing, but could also be interpreted as the Fed revising down its economic forecast and adjusting its target interest rate forecast accordingly to maintain the current stance of monetary policy.  In other words, a lower long-term interest rate forecast might simply be viewed as the Fed expecting the natural interest rate to remain depressed longer than previously expected and thus needing to hold down its target federal funds rate target longer than expected.  Here, the Fed would not be adding stimulus, but maintaining the status quo as the economic outlook worsened.

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