In an op-ed today at the WSJ, John Taylor writes:
The Fed ratcheted up purchases of mortgage-backed and U.S. Treasury securities, and now they say more large-scale purchases are coming. They kept extending the near-zero federal funds rate and now say that rate will remain in place for at least several more years. And yet—unlike its actions taken during the panic—the Fed’s policies have been accompanied by disappointing outcomes. While the Fed points to external causes, it ignores the possibility that its own policy has been a factor.
At the very least, the policy creates a great deal of uncertainty. People recognize that the Fed will eventually have to reverse course. When the economy begins to heat up, the Fed will have to sell the assets it has been purchasing to prevent inflation.
Consider the “forward guidance” policy of saying that the short-term rate will be near zero for several years into the future. The purpose of this guidance is to keep longer-term interest rates down and thus encourage more borrowing. A lower future short-term interest rate reduces long-term rates today because portfolio managers can, in a form of arbitrage, easily adjust their portfolio mix between long-term bonds and a sequence of short-term bonds.
So if investors are told by the Fed that the short-term rate is going to be close to zero in the future, then they will bid down the yield on the long-term bond. The forward guidance keeps the long-term rate low and tends to prevent it from rising. Effectively the Fed is imposing an interest-rate ceiling on the longer-term market by saying it will keep the short rate unusually low.
Research presented at the annual meeting of the American Economic Association this month by Eric Swanson and John Williams of the San Francisco Fed is consistent with this view of credit markets. It shows that during periods of forward guidance, the long-term interest rate does not adjust to events that shift supply or demand as it does in normal periods.
Hum! Is that right? In 2003-04 the Fed also provided “forward guidance”. From early 2001 to mid-2003 the economy was in the ‘doldrums’: Nominal and real growth were falling, unemployment was on the rise, long term rates and the stock market were going down and so were inflation and inflation expectations. The Fed felt there was a risk the economy would tip into deflation mode!
After trying to reverse the process with speeches about what could be done, without much success, the Fed embarked, in mid-2003, on providing “forward guidance”. The August 2003 FOMC meeting made it clear with the statement: “the FF rate will remain low (1%) for an extended period”. Later, in the March and May 2004 FOMC meeting the “forward guidance” was changed to “policy accommodation can be removed at a pace that is likely to be measured”.
The chart shows that the build-up to “forward guidance” in the May-August 2003 FOMC meetings changed the course of long term rates. Long term rates adjusted again when “forward guidance” was ‘revised’ in March-May 2004. What followed was “Greenspan´s Conundrum”, the fact that rising short rates did not raise long rates. But we now know those adjustments had already happened!
In our book, Benjamin Cole and I present the following charts. Taken together we believe they provide compelling indication that “forward guidance” worked; with all the relevant variables changing direction at the moment ”forward guidance” was implemented.
Over the past four years what we´ve had is a series of “on” and off” decisions by the Fed that haven´t helped. More recently “forward guidance” has been made more explicit, but as implied by Taylor´s article, it has not been very helpful either.
I wonder what would happen if after a FOMC meeting we learn that the Fed decided to adopt an NGDP level target.
Update: Scott Sumner has a post on Taylor