Recently, Nick Rowe put up a post to discuss “forward guidance” by the Bank of Canada. But in an inflation targeting regime, forward guidance doesn´t really have traction. According to Nick:
5. But there’s something wrong with thinking that the Bank of Canada has any degrees of freedom in setting the overnight rate target. The Bank of Canada is targeting 2% inflation. If it is serious about trying to keep future inflation as close as possible to the 2% target, it cannot freely choose a target for the overnight rate. Once it has chosen the 2% inflation target, it has used up all its degrees of freedom. It has to do what (it thinks) it needs to do to hit that inflation target. If it sticks to the 2% target, any commitment becomes a conditional commitment. But then “I promise I will set the overnight rate at 1% unless I think I need to change it to keep future inflation at 2%” is no different from “I promise I will set the overnight rate at whatever I think is needed to keep future inflation at 2%, and I think 1% will work for some time”. It’s like making a “promise” to do whatever you think you will feel like doing. It’s not a promise at all.
This led me to go back a decade and examine how forward guidance was successfully applied by the FOMC:
In 2002 things came to a head. Greenspan made the first move in a speech on November 13:
There is an implication that the notion (of fighting deflation risks) that we are restricted solely to overnight funds. But our history as an institution indicates that there have been innumerable occasions when we have moved out from short-term assets and invested in long term Treasuries. We do have the capability, if required to do so, to go well beyond activities related to short-term rates.
This was followed by Bernanke´s famous “Deflation: making sure “it” doesn´t happen here” speech one week later. He asks:
So what then might the Fed do if its target interest rate, the federal funds rate, fell to zero”? One answer: One approach, similar to an action taken in the past couple of years by the Bank of Japan, would be for the Fed to commit to holding the overnight rate at zero for some specified period…” Another: “A more direct method, which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer maturity Treasury debt…
But saying “what could be done” wasn´t enough. Unemployment kept rising, nominal spending growth didn´t get traction and real growth remained weak. The FF rate, which had be brought down to the unheard of level of 1.25% remained at that level all the way to June 2003.
In the FOMC meeting of May 2003, given that unemployment remained elevated and inflation low and even falling somewhat, there was an important innovation in the language of the post-meeting statement:
Recent readings on production and employment, though mostly reflecting decisions made before the conclusion of hostilities, have proven disappointing. However, the ebbing of geopolitical tensions has rolled back oil prices, bolstered consumer confidence, and strengthened debt and equity markets. These developments, along with the accommodative stance of monetary policy and ongoing growth in productivity, should foster an improving economic climate over time.
Although the timing and extent of that improvement remain uncertain, the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal. In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The Committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future.
In the next FOMC meeting, in June, unknown at the time to the general public, Vincent Rinehart (Director of the Board´s Division of Monetary Affairs) made a presentation called Conducting Monetary Policy at Very Low Short-Term Interest Rates”. The post- meeting statement read:
The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome substantial fall in inflation exceeds that of a pickup in inflation from its already low level. On balance, the Committee believes that the latter concern is likely to predominate for the foreseeable future.
This signaled that a change in policy was likely in the near future. That came about in the next FOMC meeting, in August 2003. The post-meeting statement said:
The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. In contrast, the probability, though minor, of an unwelcome fall in inflation exceeds that of a rise in inflation from its already low level. The Committee judges that, on balance, the risk of inflation becoming undesirably low is likely to be the predominant concern for the foreseeable future. In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.
Interestingly, at the top of Reinhart´s alternatives for monetary policy at low rates was this one:
Encouraging investors to expect short rates to be lower in the future than they currently anticipate.
Although the FF rate didn´t change, remaining at 1%, the new words, more recently labeled forward guidance, did the trick!
As can be observed in charts 4 & 6, spending growth and real output growth rose markedly and unemployment trended down.
Other indicators of the markets appreciation of the stance of monetary policy reacted accordingly. In chart 7 we show the behavior of the stock market (S&P 500) and of the yield on the 10 year Treasury Bond. The “pessimistic” decline in those indicators prior to the Fed´s policy change was immediately reversed. The stock market, being more forward looking, reacted earlier.
Chart 8 illustrates the behavior of 5 year expected inflation (from the Cleveland Fed). Any concern for an unwelcome additional fall in inflation was immediately forgotten!
The “for a considerable period” language remained a feature of the statements following the next FOMC meetings in September, October and December 2003.
After the January 2004 meeting a new signal was provided in the statement:
The Committee perceives that the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. The probability of an unwelcome fall in inflation has diminished in recent months and now appears almost equal to that of a rise in inflation. With inflation quite low and resource use slack, the Committee believes that it can be patient in removing its policy accommodation.
Indicating that the moment that rates would start rising had been brought forward.
The language remained the same in the March 2004 FOMC meeting. But after the May 2004 meeting another signal was given:
The Committee perceives the upside and downside risks to the attainment of sustainable growth for the next few quarters are roughly equal. Similarly, the risks to the goal of price stability have moved into balance. At this juncture, with inflation low and resource use slack, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.
The FOMC in effect was saying: Time´s up, but stay calm because the FF rate is not going to jump up!
On cue, the rate was raised by 25 basis points (0.25 percentage points) in the June 2004 meeting and the words at a pace that is likely to be measured remained. And it was so all the way to Greenspan´s farewell FOMC meeting on January 31, 2006, when the FF rate was raised another 25 basis points to 4.5%.
Why is present day forward guidance not having much impact, despite the promise to keep rates low “´till hell freezes over”? Maybe that has to do with the fact that as of January 2012 the Fed became a de facto inflation targeter!