Bernanke sidesteps immediate QE3, but not off the table

Communication Tools

Clear communication is always important in central banking, but it can be especially important when economic conditions call for further policy stimulus but the policy rate is already at its effective lower bound. In particular, forward guidance that lowers private-sector expectations regarding future short-term rates should cause longer-term interest rates to decline, leading to more accommodative financial conditions.18

The Federal Reserve has made considerable use of forward guidance as a policy tool.19 From March 2009 through June 2011, the FOMC’s postmeeting statement noted that economic conditions “are likely to warrant exceptionally low levels of the federal funds rate for an extended period.”20 At the August 2011 meeting, the Committee made its guidance more precise by stating that economic conditions would likely warrant that the federal funds rate remain exceptionally low “at least through mid-2013.”21 At the beginning of this year, the FOMC extended the anticipated period of exceptionally low rates further, to “at least through late 2014,” guidance that has been reaffirmed at subsequent meetings.22 As the language indicates, this guidance is not an unconditional promise; rather, it is a statement about the FOMC’s collective judgment regarding the path of policy that is likely to prove appropriate, given the Committee’s objectives and its outlook for the economy.

The views of Committee members regarding the likely timing of policy firming represent a balance of many factors, but the current forward guidance is broadly consistent with prescriptions coming from a range of standard benchmarks, including simple policy rules and optimal control methods.23 Some of the policy rules informing the forward guidance relate policy interest rates to familiar determinants, such as inflation and the output gap. But a number of considerations also argue for planning to keep rates low for a longer time than implied by policy rules developed during more normal periods. These considerations include the need to take out insurance against the realization of downside risks, which are particularly difficult to manage when rates are close to their effective lower bound; the possibility that, because of various unusual headwinds slowing the recovery, the economy needs more policy support than usual at this stage of the cycle; and the need to compensate for limits to policy accommodation resulting from the lower bound on rates.24

Has the forward guidance been effective? It is certainly true that, over time, both investors and private forecasters have pushed out considerably the date at which they expect the federal funds rate to begin to rise; moreover, current policy expectations appear to align well with the FOMC’s forward guidance. To be sure, the changes over time in when the private sector expects the federal funds rate to begin firming resulted in part from the same deterioration of the economic outlook that led the FOMC to introduce and then extend its forward guidance. But the private sector’s revised outlook for the policy rate also appears to reflect a growing appreciation of how forceful the FOMC intends to be in supporting a sustainable recovery. For example, since 2009, forecasters participating in the Blue Chip survey have repeatedly marked down their projections of the unemployment rate they expect to prevail at the time that the FOMC begins to lift the target for the federal funds rate away from zero. Thus, the Committee’s forward guidance may have conveyed a greater willingness to maintain accommodation than private forecasters had previously believed.25 The behavior of financial market prices in periods around changes in the forward guidance is also consistent with the view that the guidance has affected policy expectations.26

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