What is the Fed telling markets?

By R.A. | WASHINGTON

LAST year, the Fed began its most aggressive ever use of "forward guidance" as a monetary-policy tool, when it provided a calendar date—initially 2013, now late 2014—through which the Fed was likely to leave rates at exceptionally low levels. The meaning and intention of this language has been hotly debated ever since. On the one hand, a pure focus on the language of the Fed's statement indicates that rates are likely to remain low through that period based on the state of the economy. Here's the text:

[T]he 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 late 2014.

If the Fed is merely communicating its views of the likely trajectory of the economy and the way that trajectory is likely to influence the policy rules the Fed uses to set rates, then the forward guidance in the statement should not be stimulative. On the contrary, if it communicates to observers that the economy is weaker than widely believed the statement could actually be contractionary.

On the other hand, the Fed may be hinting that it will be willing to keep rates low through late 2014 even if the trajectory of the economy warrants a rate increase. In other words, the Fed might be attempting to commit itself to a deviation from its normal policy rules of the sort that might generate more rapid growth and inflation. If that is the Fed's intention and if markets felt the commitment was credible, then the policy would be stimulative. Indeed, this sort of commitment is one of the methods the economics literature suggests can be used to stimulate an economy in which interest rates are at the zero lower bound.

In a new paper presented at the Brookings Papers on Economic Activity four Fed economists, including Charles Evans, who is the president of the Chicago Fed, examine whether forward guidance can be an effective policy tool. The authors divide forward guidance into two categories: Delphic, corresponding to the first category above, and Odyssean, corresponding to the second, in which the central bank attempts to commit itself to deviations from typical rules.

The paper seeks to show that markets have, in the past, responded to the text of statements (they have) and to decompose those responses into those that reflect changes in Fed assessments of the economy and those that reflect perceived commitments to deviations from rules. According to their analysis, markets are used to seeking, finding, and responding to such commitments, such that an effort to use forward guidance more aggressively now is likely to bear fruit.

This is not an altogether surprising result. It leaves some questions unresolved: are markets actually responding to what they see as a Fed commitment to deviate from its rule, or are they responding to other communications in the statement? The Fed might be using its language to suggest that it is looking at variables, like oil prices, that it hasn't previously paid as much attention to or that don't feature in most monetary policy rules. It might be using its language to signal beliefs about the natural rate of unemployment, which isn't known. It is more difficult to understand the precise relationship between conditional language and market responses than the paper hints.

At the same time, the authors quite clearly make the important point that Fed's language could be tweaked to become much more effectively stimulative. In comments on the paper at its presentation yesterday, listeners seemed to agree that despite the seemingly Delphic language of the statement, the Fed had probably made it somewhat more difficult for its members to vote to raise rates prior to late 2014, and had therefore built some Odyssean guidance into its statement. Not very effectively, however. Participants seemed to agree that calendar guidance left markets quite confused about the Fed's goals, and that conditioning action on actual economic data would make much more sense.

That, of course, is what President Evans has been calling for the Fed to do for some time. He advocates a 7/3 threshold rule in which the Fed indicates that rates will not rise until unemployment falls below 7% or inflation rises above 3%. The participants in yesterday's discussion generally (though not uniformly) felt that this was likely to be more effective than the current language. Strikingly, the preference, however, was generally (though not uniformly) for a nominal level target of some sort. Nominal GDP was mentioned in positive terms more than once.

The question, as always, is why the very smart members of the Federal Open Market Committee have been reluctant to move policy in a more effective direction. Political economy concerns seem to play a role in this choice. What stands out to me, having listened to the discussion yesterday as well as Ben Bernanke's recent lectures on monetary policy, is the extent to which central bankers view the achievement of price stability, post-1970s, as an enormous and valuable victory that should not be risked. Should the Fed attempt to boost the economy and cause inflation expectations to become "de-anchored", it will then have to refight Paul Volcker's wars, at great cost.

I understand the source of this view, but I do not understand the unwillingness to subject it to close scrutiny. How vulnerable, actually, is this anchoring? Is it really probable that a two-year period in which the price index for personal consumption expenditures averages 3% annual growth is sufficient to disrupt long-term expectations? This seems incredibly unlikely. Given the probable employment benefits of that kind of inflation, central bankers ought to be forced to mount a much more aggressive defence of their inflation hawkishness than they have done so far.

Moreover, is it clear that the net benefits of this defeat of inflation volatility are so great? Perhaps they are; a simple look at the performance of macroeconomic aggregates in the postwar period versus the period from 1984 to now isn't at all conclusive. There is a real cost to extreme inflation aversion. Central bankers have done a pretty woeful job explaining the benefits of this policy, and they should be roundly criticised for this failure.