A long and contentious debate on communications is set to occupy most of the Federal Reserve’s time when it meets on Tuesday and Wednesday next week... Three different issues are tangled together. The first is whether to clarify the Fed’s goal by agreeing on a clear inflation objective. Second is explaining how the Fed is likely to change policy in the future to reach that goal. Third is whether to use communication to ease policy now with, for example, a pledge to keep rates low until unemployment falls to 7 or 7.5 per cent.A working group is attacking the problem from first principles, with every option – including innovations such as setting a target for growth in nominal gross domestic product over time – up for discussion.
I am glad to see them include a nominal GDP target in their discussion, but there is a more important point here. One of the key reasons behind the Fed's inability to restore robust nominal spending is its inability to clearly communicate the future path of monetary policy. By failing to properly shape expectations about where it wants to guide the nominal economy, the Fed has created much uncertainty. There is no way programs like QE2 and Operation Twist will have lasting power if there is no explicit and well understood target assigned to them. That is why these talks are important. As Nick Rowe explains, the Fed is one of the worst communicators among central banks so anything would be an improvement.
And for those who question whether expectations really do make that much difference take a look at the figure below. Using data from the Survey of Professional Forecasters, it shows the average annualized quarterly growth rate forecasted for nominal GDP over the next year and compares it to the actual growth of nominal GDP over the next year. It shows that a systematic and positive relationship exists between the two measures.
Along these same lines, Josh Hendrickson and I have a working paper that I am presenting next month at the SEA meetings in Washington, D.C. that shows shocks (or unexpected changes) to the inflation forecast causes a rebalancing of household portfolios that in turn leads to a change in nominal spending. The importance of expectations cannot be understated.