Friday, March 9, 2012

Eeyore and Tigger Show the Failings of U.S. Monetary Policy

Betsey Stephenson and Justin Wolfers take us on a journey to Hundred Acre Wood:
Eeyore and Tigger have become central bankers. The wood's economy is suffering the repercussions of a recent honey binge. Both Eeyore and Tigger want to help the recovery along, a goal they hope to achieve by holding interest rates low for a long time. But each communicates this differently.
Chairman Eeyore is a true dismal scientist, who sees bad news everywhere. He's sure the economy will be in the doldrums for years. Indeed, he's so worried that folks who don't understand his pessimistic outlook will make bad decisions that he gives a speech warning them about it. He says the economy is so weak that he'll need to keep rates low for several years. Eeyore's message is so sobering that it mutes the desired stimulus effect of the low interest rates. After all, why would you buy anything, or invest in producing it, if you have just learned that some of the smartest forecasters in the country think the economic outlook is so awful that they dare not raise rates until 2014? 
Chairman Tigger has a totally different approach. He figures that the prospect of a terrific party will revive everyone's animal spirits. He also knows what folks are thinking: Every time the economy gets going, the Fed spoils the party by taking away the punch bowl -- that is, by raising interest rates to keep inflation in check. So Tigger gives a speech promising to keep interest rates low for several years -- even when the economy recovers.The prospect of low interest rates sustaining a long and robust recovery leads everyone to start spending. After all, good times are just around the corner. 
Eeyore and Tigger both did essentially the same thing. They announced that interest rates would be low for several years. But their messages are importantly different, and so yield very different effects.
Their point is that Ben Bernanke has been acting too much like Chairman Eeyore.  I agree, but would add that it is nearly impossible for Bernanke to act differently given the format of the new long-term interest rate forecasts.  The format shows where FOMC officials expect the federal funds rate to be over the next few years.  What is missing and essential for knowing the stance of monetary policy is the expected natural (or equilibrium) federal funds rate.  A  federal funds rate is only stimulative if it is below its natural rate level.  It is not enough for the federal funds rate to be low, for the natural interest rate could be low too.

If the FOMC would show the forecasts of the actual and the natural federal funds rates over the various forecast horizons, then the public could know with much more clarity the Fed's intentions. Until then, the Fed's new communication strategy is at  at best white noise to the market and at worst worst a quagmire of confusion. 


  1. David
    The format is wrong. But it was Bernanke who "designed" it. Test score:F

  2. The Fed also makes forecasts for inflation, GDP, and unemployment. Couldn't you combine these forecasts with their interest rate forecast and get a pretty good guess at where they think the natural interest rate will be?

  3. Andy,yes you could but for the last release they actually revised down some of their forecast for the next year. So it appeared they were implicitly lowering their natural rate forecast. Not a very stimulative message.

    Why not just cut to the chase and say the natural is X% and we promise to keep the ffr below until Y happens?

  4. Marcus, yes this would be simplified by simply doing a NGDP level target.

  5. That last part should read:

    "Why not just cut to the chase and say the natural is X% and we promise to keep the ffr below the natural rate until Y happens?

  6. They revised down some of their forecast, but they also extended their ZIRP projection (and made an explicit set of federal funds rate projections for the first time), so I don't think that constitutes a tightening. IIRC financial markets reacted favorably to the announcement, so I'd say it was probably interpreted as a loosening of policy despite the downward revisions (although maybe the markets just liked the greater explicitness, reducing uncertainty about Fed policy).

    I would certainly be happy to see the Fed become even more explicit about its reaction function, but I can understand the institutional problems with moving more quickly in that direction. I think the main problem now is not that they aren't being explicit enough but that, if you read what's implicit in their projections, it's really rather a hawkish policy.

    The problem is not that they're being pessimistic. (I don't think they're projections were much different from the consensus at the time.) The problem is that they are implicitly promising that, if things go better than expected, they will start to lean against further improvement.

    Part of the problem, maybe, is that the projections don't go far enough into the future. Ordinarily, projecting 2014 in January 2012 would seem like enough, but under the circumstances, with the zero bound in play, it may not be. If we interpret their 2014 projections (implied about 5.5% NGDP growth in that year) as intended to continue for several years, then the implications don't seem quite so hawkish.

  7. Andy,

    In its last meeting, the FOMC lowered its forecast for real GDP for 2012 and 2013 at the same as it pushed out its forecast of low rates to 2014. To me that looks like the Fed is saying the economy is weaker than it thought it would be through 2013 and so it has to maintain the ffr at its low level longer.

    If nothing else, don't you think the fact that we are even having this discussion speaks to the lack of clarity and thus effectiveness of this new communication policy?

    Yes, one cannot expect too much from them in making changes. Hopefully this will be a first step.

    P.S. One could argue that the long-run ffr forecast is the natural rate ffr. But that doesn't help here because the public needs to know that the Fed has the ffr below the natural ffr in the near term.

  8. The FED like everybody else was to weak.

    The US economy is on the verge of a major economic boom. The liquidity train hasn't stopped globally and some of the Asian parts of that liquidity train are attempting(and succeeding thus far) in putting some of it back in America. They need a growing American economy even more than we do in many respects.

    This will boost jobs, RE and speed up deleveraging. Once that ends, the whole economy will go into boom by probably about 2014.

    The boom that began in 1983 won't end to debtholders can't keep interest rates lower anymore and destroys america's ability to borrower. That is when the music will stop.

    The FED was right to be cautious. Now we wait for the upwardly revised forecasts and policy normalization.

  9. "If nothing else, don't you think the fact that we are even having this discussion speaks to the lack of clarity and thus effectiveness of this new communication policy?"

    Yes, I agree that the policy is not as clear and effective as it should be, and if I were the King of the Fed, I would certainly do things differently. Nonetheless, I recognize that the Fed is a messy institution that has to find verbal consensus among people with disparate ideas, and I expect that there is, in that context, a tradeoff between clarity and consensus -- and that even there the Fed's tradeoff is likely to be biased toward consensus rather than clarity, as compared to what would be optimal for the country. I'm just saying we should make the best of what we have by trying to find as much clarity as we can in the Fed's statements. That means drawing logical implications from what the Fed says and holding it responsible for those logical implications.