Thursday, December 13, 2012

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.


The Arthurian said...

"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."

Okay, but what if the problem lies elsewhere? What if the problem continues to be the need for deleverage? Perhaps low interest rates help more than high rates. But there is still no direct policy action to speed up deleveraging. So it seems to take forever, and there is still no recovery. And Bernanke's best solution is to spare himself "the embarrassment of repeatedly re-adjusting the date in its forward guidance." I am not impressed.

Good twist in the ending of your post. But "trying to come up with the best policies they can" is just not good enough. They need to address the problem: excessive private debt.

The Arthurian said...

Interest rates and accumulated debt are closely related: Together they determine the total cost of credit in the economy. Thus if interest rates are so low they cannot go lower, the way to reduce the cost of credit is to reduce accumulated debt.

Bill C said...

Thanks for the comments.

One of the big policy disappointments over the past several years is the failure to have a more effective mass write-down of mortgage debt. I'd put that mainly on the administration, not the Fed.

I think the main mechanism for the Fed to facilitate 'de-leveraging' would be to aim for higher inflation. I don't think that's your preference, though, and while the 2.5% threshold and some of its other recent statements seem to indicate that its treating its objectives more symetrically, I don't see any sign we should worry about (or hope for) a significant increase in inflation.

Ryan Avent expresses the pro-inflation critique of the Fed on the economist Free Exchange blog:

The Arthurian said...

Bill, I have a big smile on my face because you know what I think.

We had lots of inflation during the years we were creating all that debt. Why should we have inflation again while we destroy it? (I understand inflation can help reduce debt. But that approach is like going off on a tangent. Economic problems should be treated like math problems. Almost no one thinks that way. Wish I could say this better.)

Some people call for an unwinding: Let banks collapse, let debt be wiped out quickly, let prices fall. Ouch! (But at least that solution is conceptually related to the problem.)

There has to be a middle ground.

Bill C said...

Hmmm... inflation rates were pretty moderate during the 2000s, though some might argue that the Fed should look at asset prices as well as goods prices; had it done so it would have tightened and pre-empted some of the credit boom (given where unemployment was, though I'd hesitate to join those who make the 'too loose' critique of the Fed in the mid-2000s).