Wednesday, January 4, 2012

FOMC Decides to Focus on the Rudder, Not the Destination

The FOMC minutes from the December meeting reveal that starting this month the Fed will start publishing conditional long-term forecasts for the federal funds rate in its Summary of Economic Projections (SEP):
At the conclusion of their discussion, participants decided to incorporate information about their projections of appropriate monetary policy into the SEP beginning in January. Specifically, the SEP will include information about participants' projections of the appropriate level of the target federal funds rate in the fourth quarter of the current year and the next few calendar years, and over the longer run; the SEP also will report participants' current projections of the likely timing of the first increase in the target rate given their projections of future economic conditions.
So what to make of this new policy?  One view is that it provides more certainty about the future path of the target policy interest rate.  Consequently, it would easier to make long-term investment decisions and that added certainty by itself might add some stimulus to the economy.  The long-term forecast could also be used as a back-door way to provide more monetary stimulus to the economy.  The Fed could do this by lowering its long-term forecast of the target federal funds rate which could be interpreted as indicating greater than expected monetary stimulus in the future.  This, in turn, would improve the economic outlook and thereby encourage households and firms to increase their spending today.  In short, a lower forecast of the future target federal funds rates could raise current aggregate demand. 

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 by the Fed. 

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.

P.S. Cardiff Garcia notes another problem with this new policy:
One longstanding concern about doing this is that the public might misinterpret the projections as a promise of what the Fed will do rather than something contingent on how the economy performs over time, and the minutes noted that at least one committee member expressed this worry.


  1. I continue to find it somewhat odd (to say the least) that the Fed can announce a target for one of its policy instruments but at the same time refuse to state what it actually it targeting. Its like giving the directions on a map with out telling where you want to go...bizarre.

    And why not give a path for QE? With interests close to zero the main policy tool is QE so why not tell how much QE will be implemented?

    This whole thing seems to me a like an attempt to be cool and smart among certain academic with no real insight to monetary policy. I am not impressed.

  2. I think the inflation forecast will act as a back-door NGDP target. There are lots of kinks in the plan, but it could morph into an expectations-setting regime.

    Let's say the Fed wants NGDP of 6% and thinks GDP will be 2%. It publishes a forecast of 4% inflation as a result of the expected path of policy: ZIRP through 2014. Assume TIPS spreads remain at 2% despite the forecast. The Fed can then "ease" by forecasting 4% inflation with even easier policy: ZIRP through 2015, or a forecast of a $2tr larger balance sheet. Once the TIPS spread rises to 4%, it can begin to tighten its forecasted policy trajectory. To Cardiff Garcia's point, there is contingency to the policy forecast, but only insofar as meeting the inflation forecast is concerned.

    As I said, there are many pitfalls in the way they might be setting this up. A rules-based targeting regime would be more efficient. However, the ad hoc one gives the Fed more discretion to 1) manage conficting views within the Fed; and 2) reduce public accountability for meeting targets.

  3. BTW, the above regime would have a "Chuck Norris" aspect. If the $2tr QE forecast manages to raise the TIPS spread to 4%, the Fed need not actually purchase $2tr in assets.

  4. Lars,

    I suspect the new policy reflects the political realities the Fed faces, rather than ineptness.

  5. David Pearson,

    I hope you are right and that it works according to plan, but the convoluted nature of it makes me skeptical.

  6. "FOMC Decides to Focus on the Rudder, Not the Destination"

    That is the best headlines maybe ever written---congrats to Beckworth.

    This should become one of the mantras of the our criticism of the Fed.

  7. But isn't more transparency better than none? I mean, surely, it is not the first best outcome, but I like this better than more discrete actions, especially if they would make a QE forecast aswell.

  8. I am concerned that the new Fed effort will merely strengthen the "monetary policy is interest rate policy" view, to the detriment of the "monetary policy is AD policy" that market monetarists are (correctly!) so intent on pushing.

    And as Lars states, the Fed apparently isn't going to publish conditional forecasts for its two most important policy tools: the IROR and the level of QE. Not a good start.

    First best might look something like: a target path for NGDP (say, a level eight quarters out) along with an unconditional commitment to enough QE to make it happen. But we don't live in that world.

  9. Anonymous,

    It does add some clarity about what the FOMC is thinking, so yes that is nice. It just seems the Fed is trying so hard with all these different unconventional monetary experiments--QE1,
    QE2, Operation Twist, long-run ffr forecast--with limited success. One would hope that eventually the importance of an explicit target would be become clear.

  10. Integral,

    Good point. In terms of my analogy, the captain has always been looking at the rudder but now is focused even more and making projections about when he will eventually turn it. And yes, it seems the Fed would want to say something about the IOR in terms of future monetary policy.

  11. David Pearson has a good point. I would note also that the Fed forecasts real growth, so one could, if one were so inclined, interpret its set of forecasts as a nominal GDP target. The problem, though, is that, if it is to be interpreted as a target, it is probably more like a growth rate target than a level target: the Fed will almost certainly not systematically revise its future growth and inflation projections in the opposite direction from past forecast error, and even it were to do so, it wouldn't be by enough to offset the forecast error completely. I would suggest that the biggest problem with the Fed's policy regime -- and a problem that is not mitigated by the recent announcement -- is that it is consistently willing to forgive its own past failures without making amends. (Note that the behavior of the nominal GDP series over the past 30 years is consistent with having a unit root, and it remains so if you truncate at 2007.)

  12. It is time Market Monetarists define the debate.

    What the Fed and other monetarists are practicing is "theo-monetarism."

    Theo-monetarism, as practiced, is resulting in recessionary deflations in Europe and the USA, and a Japan-like economy.

    Japan has an extremely strong yen. Japan has had 15 percent deflation in the last 20 years. Japan's manufacturing output has fallen 20 percent in that time period, while stock and equity markets cratered by 80 percent. Banks suffer continual losses on real estate and loans in nominal yen.

    You call that "theo-monetarism." A faith that an undefined, oblique, ad hoc "tight money" policy works, despite abundant empirical evidence to the contrary.

    Theo-Monetarism is a faith-based monetarism, for those who genuflect to gold and worship the idea of a stagnant paper currency.

  13. Given the importance of expected higher NGDP in aiding the recovery, I find it terrible that the Fed is focusing its communications strategy on the rudder and not the destination. (Good metaphor, by the way).

  14. The metaphor is great. I'll extend it. The crew cares a lot about where the ship will end up, but the captain won't say. Instead they listen intently to every word she utters and watch every move she makes to improve their forecast of the ships destination. All of the crew members make decisions that influence the direction of the ship, but because nobody knows the destination, many are working against each other, pushing the ship to and fro. The captain has to work extra hard to get the ship to this secret destination (and secretly loses confidence in her ability to steer the ship at all). Alas, if the captain would just announce the ship's destination, the crew would work harmoniously making it much easier for the captain to get where she wants to go.