Monday, January 23, 2012

The Fed's Long-Term Interest Rate Forecast May Backfire

The Fed is about to release it first long-term interest rate forecast. Gavyn Davies explains how this could enable U.S. monetary policy to add more stimulus without actually expanding its balance sheet. It would do so  by managing nominal expectations. Here is Davies:
What is the motivation behind these changes? Mr Bernanke has normally justified such steps in terms of stabilising expectations about the Fed’s genuine intentions, especially on inflation and the forward path for interest rates. At a time when the extension of the balance sheet is causing political difficulties for the Fed, and when inflation expectations could become unhinged by the rapid expansion of the monetary base, the chairman is looking for alternative ways of easing monetary conditions without printing more money. Modern macro-economics suggests that operating on expectations is one of the most powerful tools available to him, though he is using it much more cautiously than many economists would like to see...
[T]he new mechanism will provide the Fed with a potentially important tool to influence expectations, and therefore the course of the economy. Paul Krugman was the first to argue in the 1990s that, in the modern version of the liquidity trap, an economy could get stuck permanently with high unemployment because of undesirable expectations of deflation. With short rates not able to drop below zero, the real rate of interest could be too high to equilibrate savings and investment in the economy, so the normal monetary route back to lower unemployment might be blocked. The answer, said Krugman, was for the central bank deliberately to increase the expected rate of inflation, and therefore to cut the real rate of interest while nominal short rates were fixed at zero.
That is how the Fed hopes it will turn out. I think it will backfire because what observers really need is to know where the expected path of the federal funds will be relative to the expected path of the natural (or equilibrium) federal federal funds.  Here is what I said about this previously:
The FOMC lowering its expected path of the target federal funds rate, however, might also be interpreted as the Fed revising down its economic forecast and adjusting its target interest rate forecast accordingly to maintain the current stance of monetary policy.  In other words, a lower long-term interest rate forecast might simply be viewed as the Fed expecting the natural interest rate to remain depressed longer than previously expected and thus needing to hold down its target federal funds rate target longer than expected.  Here, the Fed would not be adding stimulus, but maintaining the status quo as the economic outlook worsened. Given the Fed's failure over the past three years to add sufficient stimulus to restore robust nominal spending and close the output gap, this less favorable interpretation in the current environment would amount to more passive tightening.
Gavyn Davies also recognizes another problem with using this policy innovation to steer monetary policy via expectations management: it may not be credible. Credibility, however, would not be a problem if the Fed would set an explicit nominal destination.  Doing so would avoid the time inconsistency problem that concerns Davies.  From my same post:
That there could be different interpretations of the Fed lowering its long-term forecast for the target federal funds rate speaks to a more fundamental problem with this new policy: the Fed has failed to set an explicit nominal target for monetary policy.  Not knowing where the Fed is ultimately heading makes it difficult to interpret changes in the FOMC's long-term interest rate forecast. It is like a captain of a ship who navigates by focusing on the rudder, but fails to set a destination point.  It would be far better for the captain to pick his target destination and then adjusts the rudder accordingly.   This is why it is so important for the Fed to set a nominal GDP level target.  It would provide a clearer road map of where the Fed wants the nominal economy to go and it would make interpreting changes in the expected path of interest rates easier, if not redundant.  It is time for the Fed to focus on the destination.
Okay, so the Fed is not likely to announce a NGDP level target tomorrow.  I do wish, though, that it would  also provide the expected path of  the natural federal funds rate on its long-term interest rate forecasts.  If so, it would help the public better understand the implications of the FOMC's expected path of the federal funds rate. 


  1. kid dynamite thinks it will backfire too; his take:

    I disagree with the theory that placating market assumptions about interest rates in the future – reassuring the market that rates will stay low for a long time - will make it more likely for people to want to borrow NOW. Let me explain: right now, one appealing factor of home buying/selling decisions is that interest rates are very low – you can afford to buy more house. If I think that interest rates are going to remain low for a long period of time, I will be in no hurry to lock in this low rate on the debt I’m borrowing – I will be in no hurry to go out and buy a house….. Same for issuing fixed rate debt: if I’m a company looking to expand and I think interest rates will be going higher, I have more incentive to borrow money NOW, at this low rate. But if the Fed assures me that rates will be low for a long time, then I have no reason to rush my borrowing (and subsequent spending) plans. It seems to me that by assuring the Market that rates will be low for a long period of time, the Fed is giving borrows an excuse to NOT borrow (and thus not spend) now with any sense of urgency.

  2. "I think it will backfire because what observers really need is to know where the expected path of the federal funds will be relative to the expected path of natural (or equilibrium) federal federal funds."

    What if the natural (or equilibrium) federal funds rate is zero or negative and remains there for years?

    What is the explanation for a natural (or equilibrium) federal funds rate of zero or below?

  3. RJS,

    Kid Dynamite's response is another reason why I think the neutral rate is important. Since the neutral rate is closely related to the state of the economy, one could roughly view it as the return on America Inc. If the Fed says it will keep its policy rate below the return on America Inc. it is creating a strong incentive to borrow and invest in America Inc. Moreover, the longer the Fed does this the greater the effect. And hopefully, by convincing the public it committed to doing this, the public will respond by borrowing today in anticipation of the improved economic gains.

  4. Anonymous,

    The neutral federal funds rate (ffr)is closely tied to the state of the economy. If the economy takes off so does the neutral ffr. The fact that is so low now is simply a reflection of the current slump.There are more technical ways to think about it--e.g. the rate that equates desire savings with desired investment--but the implications are the same.

    Thus, if one believes that much of the slack in the economy is due to insufficient aggregate demand (AD), then the solution is straightfoward: keep the actuall ffr below the neutral ffr until rapid AD growth closes the output gap. The rapid economic growth this would create would push the neutral ffr back up to normal levels.

    On the other hand, if one believes that real or structural problems are the main culprit then it is less clear what policy can do, other than have policies that encourage the market to naturally adjust. The netural ffr should eventually go up here too, unless one believes that the long-run trend growth rate of productivity (which influences desired investment) is now significantly lower. I have a hard time see this latter possibility.

  5. I'm of the opinion that the most likely scenario is that real or structural problem(s) are leading to insufficient AD. By AD, do you mean real AD or nominal AD?

    "The netural ffr should eventually go up here too, unless one believes that the long-run trend growth rate of productivity (which influences desired investment) is now significantly lower."

    I also believe that positive productivity growth can lead to a lower natural (or equilibrium) federal funds rate (assuming I'm reading that correctly).

  6. Anonymous,

    a higher productivity growth rate should, all else equal, lead to a higher neutral rate. This is because higher productivity growth rate causes firms to invest more (expect higher profits) and households to spend more (expect higher incomes). Currently, though, expected productivity growth rate is actually falling. See here:

  7. "This is because higher productivity growth rate causes firms to invest more (expect higher profits) and households to spend more (expect higher incomes)."

    Only if the productivity gains are distributed evenly and evenly in time?

    I don't believe that is what is happening/has been happening. IMO, the gains have been tilted toward the firms. In budget terms, the firms have been experiencing positive real earnings growth, while the workers have been experiencing negative real earnings growth by their budget. The workers have been using debt to make up the difference for negative real earnings growth. The productivity gains tilted toward the firms and lack of wages per hour rising enough (cheap labor helps here too) is why price inflation has not taken off in tradable goods (we are not going to let the 1970's happen all over again).

    Eventually, rich firms (Apple, Google, Microsoft, Cisco, Intel, etc.) stop investing enough to increase capacity because they can make enough product (although they will keep investing to lower product cost and/or lower employment to attempt to expand margins). Also, rich people stop spending because they have enough already. Think Warren Buffett, Bill Gates, etc.

    The question is whether the labor market will have to be affected directly instead of indirectly.

    Here is one (or two) last thought on positive productivity growth. If workers figure out that the gains will be used to reduce employment instead of expanding capacity, will they spend more? Will they be able to afford their monthly debt payments?