The End of Mystique

Until fairly recently, central banks tended to be secretive and cultivate a "mystique" (hence "Secrets of the Temple" as the title for the 1987 William Greider book about the Fed, which helped inspire my interest in economics). In the early 1980's Karl Brunner explained (via Marvin Goodfriend):

Central Banking [has been] traditionally surrounded by a  peculiar and protective political mystique. Criticism of Central Banks, if it occurred at all in the political arena, [has been] muted and infrequent. The Federal Reserve operated in the USA over decades with little criticism from the public or its political representatives. The same phenomenon can be found in many other countries. The political mystique of Central Banking was, and still is to some extent, widely expressed by an essentially metaphysical approach to monetary affairs and monetary policy-making. The possession of wisdom, perception and relevant knowledge is naturally attributed to the management of Central Banks. The possession of such knowledge and perception bearing on matters of concern to Central Banking is a function of the political position. The relevant knowledge seems automatically obtained with the appointment and could only be manifested to holders of the appropriate position. The mystique thrives on a pervasive impression that Central Banking is an esoteric art. Access to this art and its proper execution is confined to the initiated elite. The esoteric nature of the art is moreover revealed by an inherent impossibility to articulate its insights in explicit and intelligible words and sentences. Communication with the uninitiated breaks down. The proper attitude to be cultivated by the latter is trust and confidence in the initiated group's comprehension of the esoteric knowledge.

Things have changed a great deal since then, and the pace of change has accelerated.  In a recent speech, Fed Vice Chair Janet Yellen traced this "revolution" in central bank communication, which academic economists generally regard as an improvement.  It was only in 1994 that the Fed began announcing changes in the federal funds rate target, and I was pretty surprised last year when Bernanke began holding press conferences.

Given all the recent changes, I shouldn't have been surprised to see a further step towards greater central bank openness - Federal Reserve banks are now sending jokey tweets:

So much for that mystique.

New From the Fed: TBG

That is, "Threshold Based Guidance." 

The Federal Open Market Committee's statement today included the following:

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. In particular, the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

Since the federal funds rate hit the zero lower bound - four years ago - other monetary policy tools have taken on a more prominent role.  One of them is the Fed's ability to influence expectations, which it tries to do by making promises about future policy ("forward guidance").  Because long-term interest rates depend on expected future short term rates, convincing people that short-term rates will be low for longer can bring down long-term rates, and thereby reduce the cost of investment and credit purchases.  One of the difficulties that the Fed has to get around, though, is that people believe it places a high priority on keeping inflation low and would tighten policy at any hint of the economy heating up.  As Mark Thoma explains:

The Fed believes that policy will be most effective if it can convince people policy will remain loose even after there are signs of a strong recovery.

However, one of the problems the Fed has had in its communications strategy is convincing people it will carry through with this commitment even if inflation drifts above the 2 percent target. In some sense, the Fed has too much credibility on inflation.

The adoption of numerical thresholds -- in particular an inflation threshold that is a half a percent above target and the commitment to maintain present policy "at least" until the thresholds have been met -- is an attempt to overcome this communication problem though a commitment to a clear, well-defined policy rule.

This month's announcement was a shift from its previous statements, which had provided forward guidance in terms of the timing of expected rate increases - e.g., in October, the FOMC said "exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015."

Of course, quite a lot can happen between now and mid-2015 and the economy may do considerably better or worse than anticipated. Nobody really believes the Fed would keep the federal funds rate target at zero through mid-2015 if the economy suddenly boomed in 2013 (and, though some seemed to interpret it that way, its wasn't trying to claim that it would).  Alternatively, if things aren't much better in 2015, the fed funds rate could stay at zero considerably longer.

Shifting to thresholds spares the Fed the embarrassment of repeatedly re-adjusting the date in its forward guidance.  Announcing that it will allow forecast inflation to go up to 2.5%, which is 0.5% above the long run goal it formalized in January, seems to be an attempt to convince everyone that the Fed doesn't treat its 2% goal as a "below, but close to" target like the ECB does, and that it is willing to give a little on the "stable prices" side of its "dual mandate" in service of its other objective, "maximum employment."  But it won't let inflation get out of hand (or even close) - its a "dovish" statement only  by the standards of monetary policy discourse long-dominated by inflation "hawks".  Stating the goal in terms of the Fed's forecast of inflation means that it won't feel obliged to tighten in response to a burst of inflation it sees as transitory (e.g., due to an energy price shock).  However, putting it in terms of forecast inflation also makes it a little squishier (which is part of Stephen Williamson's critique).

In his press conference, Ben Bernanke also suggested that the threshold based guidance had an "automatic stabilizer" characteristic (and it appeared he was making this argument off the cuff): in the event of a negative shock to the economy, the threshold would cause markets to lengthen the period of expected zero short-term rates, which would bring long-term rates down.  A positive shock would cause the market to expect the threshold for potentially raising rates to come sooner, which would lead to higher long-term rates.

The other part of the Fed's announcement was that it planned to purchase $45 billion of Treasuries per month, which is intended to continue the expansionary effect of its effort to shift the composition of its balance sheet towards longer maturities ("operation twist").  It will also continue to buy $40 billion of mortgage backed securities per month.  This follows through on its October statement that it would be purchasing assets and expanding its balance sheet with no definite limit or end date until a substantial improvement in the labor market "is achieved in a context of price stability."

Overall, the Fed really seems to be stepping up to the plate and seriously trying to address the crisis of persistent high unemployment as best it knows how.  Bernanke's genuine concern about unemployment was evident in the press conference.

Of course, it remains to be seen how much effect the Fed's policies will really have (the Economist's Greg Ip struck a cautionary note) and fiscal policy appears likely to be either somewhat, or highly, contractionary in the coming year depending on the outcome of the "fiscal cliff" bargaining.

As an academic economist, I was particularly amused by Bernanke's response to a question in the press conference about how the FOMC chose the thresholds.  He said that they were based on staff assessments "under so-called optimal policy, or in the best policy that we can come up with, what would the interest rate path look like and how would it be connected or correlated with changes in unemployment and inflation."  That embodies the tension between academic and policy-making economics.  Bernanke comes from the academic world, where we write and discuss papers about "optimal" policies - usually specified in terms of the utility functions of "agents" in the economy - but he now works in the world of "the best policy that we can come up with".

We academics will be debating how sub-optimal the Fed's policy is for years, but at least they're trying to come up with the best policies they can.

See also: Binyamin Applebaum's NYT story, Neil Irwin, Michael Woodford and David Beckworth.

A Review of Roger Farmer's Books

My review of Roger E.A. Farmer's Expectations, Employment and Prices and How the Economy Works: Confidence, Crashes and Self-Fulfilling Prophecies has finally appeared in the Eastern Economic Journal.

Farmer's ideas are spiritually Keynesian, but he accepts the belief which developed out of the work of Friedman, Lucas and others, that macroeconomic theory should be consistent with microeconomic optimization.  His point of departure from standard DSGE models (both of the Real Business Cycle and New Keynesian varieties) is that he allows for the lack of a unique equilibrium in the labor market.  This opens up a key role for asset values and confidence in determining output, with the policy implication that monetary policy should be directed at stabilizing asset prices.

Expectations is addressed to a professional audience economics book, while How the Economy Works second is written for a general audience.  How the Economy Works also provides a nice overview of how macroeconomics has evolved which would be a good background for laypersons and students about some of the debates within the field.

A subscription is necessary to read the review, which concludes:

The financial crisis and recession have led to considerable hand-wringing and soul-searching by macroeconomists. Caballero [2010, p. 85] argues that “macroeconomic research has been in ‘fine-tuning’ mode within the local-maximum of the dynamic stochastic general equilibrium world, when we should be in ‘broad-exploration’ mode.” Farmer's work answers that call nicely. It is a synthesis in the best sense of the word, blending Keynesian insight with key subsequent developments such as rational expectations, the permanent income hypothesis and the search model of the labor market. It deserves the attention of macroeconomists, who will find it a healthy challenge to their thinking.