Hutchins Center PILE INTERNATONAL ECONOMICS on Fiscal Monetary Policy at BROOKINGS MONETARY POLICY INA NEW ERA Ben s bernanke Brookings Institution October 2. 2017 Prepared for conference on Rethinking Macroeconomic Policy, Peterson Institute, Washington DC. October 12-13. 2017. The author is a distinguished Fellow at the brookings Institution and the Hutchins Center on Fiscal and Monetary Policy. I thank Olivier Blanchard, Donald Kohn and David Wessel for comments and Michael Ng for excellent research assistance
MONETARY POLICY IN A NEW ERA Ben S. Bernanke Brookings Institution October 2, 2017 Prepared for conference on Rethinking Macroeconomic Policy, Peterson Institute, Washington DC, October 12-13, 2017. The author is a Distinguished Fellow at the Brookings Institution and the Hutchins Center on Fiscal and Monetary Policy. I thank Olivier Blanchard, Donald Kohn, and David Wessel for comments and Michael Ng for excellent research assistance
In 2017, the flagship research conferences of the European Central Bank and the Federal Reserve-held in Sintra, Portugal, and Jackson Hole, Wyoming, respectively--had something in common: Both had official themes unrelated to monetary policy, or even central banking. The ECB conference(theme: Investment and Growth in Advanced Economies)did include an opening speech by President Mario Draghi on monetary policy and the outlook, before turning to issues like the prospective effects of technological advances on employment. However, the Fed's meeting(theme: Fostering a Dynamic Global Economy), which included papers on topics ranging from fiscal policy to trade to income distribution, made almost no mention of monetary policy. Whether intended or not, the signal, I think, was clear. After ten years of concerted effort first to restore financial stability then to achieve economic recovery through dramatic monetary interventions, central bankers in Europe and the United States believe that they see the ight at the end of the tunnel. They are looking forward to an era of relative financial and economic stability in which the pressing economic issues will relate to growth, globalization, and distribution--issues that are the responsibility of other policymakers and not primarily the province of central bankers Would that it were so simple. Although central bankers can certainly hope that the next ten years will be less dramatic and demanding than the past ten, there will certainly be important new challenges to be met. In this note, I focus selectively on two such challenges: the implications of the secular decline in nominal interest rates for the tools and framework of monetary policy, and the status of central banks within the government, in particular, the questions of whether central banks should and will retain their current independence in making monetary policy. As I will explain, the two challenges are related, in that the low-inflation, low- interest-rate environment in which we now live calls into question some of the traditional rationales for central bank independence The long-term decline in nominal interest rates is well known and has been extensively studied (Rachel et al., 2015). The decline appears to be the product of many causes, including lower inflation rates; aging populations in advanced economies( Gagnon et al., 2016a); slower productivity growth and"secular stagnation"( Summers, 2015); global patterns of saving and investment(Bernanke, 2005); and increased demand for"safe "assets(Del Negro et al., 201 Caballero et al., 2017). Some of these factors may reverse in the medium term--for example
1 In 2017, the flagship research conferences of the European Central Bank and the Federal Reserve—held in Sintra, Portugal, and Jackson Hole, Wyoming, respectively—had something in common: Both had official themes unrelated to monetary policy, or even central banking. The ECB conference (theme: Investment and Growth in Advanced Economies) did include an opening speech by President Mario Draghi on monetary policy and the outlook, before turning to issues like the prospective effects of technological advances on employment. However, the Fed’s meeting (theme: Fostering a Dynamic Global Economy), which included papers on topics ranging from fiscal policy to trade to income distribution, made almost no mention of monetary policy. Whether intended or not, the signal, I think, was clear. After ten years of concerted effort first to restore financial stability, then to achieve economic recovery through dramatic monetary interventions, central bankers in Europe and the United States believe that they see the light at the end of the tunnel. They are looking forward to an era of relative financial and economic stability in which the pressing economic issues will relate to growth, globalization, and distribution—issues that are the responsibility of other policymakers and not primarily the province of central bankers. Would that it were so simple. Although central bankers can certainly hope that the next ten years will be less dramatic and demanding than the past ten, there will certainly be important new challenges to be met. In this note, I focus selectively on two such challenges: the implications of the secular decline in nominal interest rates for the tools and framework of monetary policy; and the status of central banks within the government, in particular, the questions of whether central banks should and will retain their current independence in making monetary policy. As I will explain, the two challenges are related, in that the low-inflation, lowinterest-rate environment in which we now live calls into question some of the traditional rationales for central bank independence. The long-term decline in nominal interest rates is well known and has been extensively studied (Rachel et al., 2015). The decline appears to be the product of many causes, including lower inflation rates; aging populations in advanced economies (Gagnon et al., 2016a); slower productivity growth and “secular stagnation” (Summers, 2015); global patterns of saving and investment (Bernanke, 2005); and increased demand for “safe” assets (Del Negro et al., 2017; Caballero et al., 2017). Some of these factors may reverse in the medium term—for example
recent historically low rates of productivity growth could revert to more-normal levels(Byrn and Sichel, 2017), and there is some evidence that the global savings glut may be moderating Chinn, 2017)which could lead to somewhat higher rates in the future. For now, though, the combination of low nominal rates and the difficulty of reducing short-term interest rates(much) below zero implies that monetary policymakers may have limited scope to address deep economic slowdowns through the traditional means of cutting short-term interest rates. Recent research by Kiley and Roberts(2017)illustrates the potential severity of the problem. Based on simulations of econometric models, including the Fed's main model for forecasting and policy analysis, these authors show that the use of conventional, pre-crisis policy approaches could lead to policy rates being constrained by the zero lower bound(zlb)as much as one-third of the time, with adverse effects on the Fed s ability to hit its 2 percent inflation target or to keep output near potential. I How should central banks respond? Outside of making a stronger case for proactive fiscal policies, there are two broad possibilities (interrelated and not mutually exclusive). First rather than relying on the management of short-term interest rates alone, as assumed by Kiley and Roberts, monetary policymakers could make greater use of new tools developed in recent rears. In the first main section of this paper, I review some of these tools. I argue that both forward guidance and quantitative easing are potentially effective supplements to conventional rate cuts, and that concerns about adverse side effects(particularly in the case of quantitative easing)are overstated. These two tools can thus serve to ease the Zlb constraint in the future, as argued by Yellen(2016). Two other tools--negative interest rates and yield curve control-are less likely to play important roles, at least in the United States. European and Japan policymakers have successfully employed negative rates, but overall they appear to have relatively modest benefits(because the option to hold cash limits how far negative rates can go), as well as some offsetting costs(related to their effects on certain financial institutions and markets). Yield curve control, or the direct management of longer-term interest rates, has been dopted by the Bank of Japan and makes sense in the current Japanese context. However, as I As some major central banks have employed modestly negative rates, conventional usage now often refers to the effective lower bound"(ELB)on interest rates rather than the ZlB. The Federal Reserve has not used negative rates, however. Since I am focusing on the Fed here, for simplicity I'lI stick with the ZLB acronym
2 recent historically low rates of productivity growth could revert to more-normal levels (Byrne and Sichel, 2017), and there is some evidence that the global savings glut may be moderating (Chinn, 2017)—which could lead to somewhat higher rates in the future. For now, though, the combination of low nominal rates and the difficulty of reducing short-term interest rates (much) below zero implies that monetary policymakers may have limited scope to address deep economic slowdowns through the traditional means of cutting short-term interest rates. Recent research by Kiley and Roberts (2017) illustrates the potential severity of the problem. Based on simulations of econometric models, including the Fed’s main model for forecasting and policy analysis, these authors show that the use of conventional, pre-crisis policy approaches could lead to policy rates being constrained by the zero lower bound (ZLB) as much as one-third of the time, with adverse effects on the Fed’s ability to hit its 2 percent inflation target or to keep output near potential. 1 How should central banks respond? Outside of making a stronger case for proactive fiscal policies, there are two broad possibilities (interrelated and not mutually exclusive). First, rather than relying on the management of short-term interest rates alone, as assumed by Kiley and Roberts, monetary policymakers could make greater use of new tools developed in recent years. In the first main section of this paper, I review some of these tools. I argue that both forward guidance and quantitative easing are potentially effective supplements to conventional rate cuts, and that concerns about adverse side effects (particularly in the case of quantitative easing) are overstated. These two tools can thus serve to ease the ZLB constraint in the future, as argued by Yellen (2016). Two other tools—negative interest rates and yield curve control—are less likely to play important roles, at least in the United States. European and Japanese policymakers have successfully employed negative rates, but overall they appear to have relatively modest benefits (because the option to hold cash limits how far negative rates can go), as well as some offsetting costs (related to their effects on certain financial institutions and markets). Yield curve control, or the direct management of longer-term interest rates, has been adopted by the Bank of Japan and makes sense in the current Japanese context. However, as I 1 As some major central banks have employed modestly negative rates, conventional usage now often refers to the “effective lower bound” (ELB) on interest rates rather than the ZLB. The Federal Reserve has not used negative rates, however. Since I am focusing on the Fed here, for simplicity I’ll stick with the ZLB acronym
will discuss, the depth and liquidity of the markets for U. S. government securities would make it difficult for the Fed to peg rates beyond a horizon of two years or so Although unconventional tools can increase the potency of monetary policy, the ZlB is still likely to be a binding constraint on the monetary response to a downturn that is more serious, or which occurs when rates remain(like today) below neutral levels. A second broad response to the problem is to modify the overall policy framework, with the goal of enhancing monetary policymakers'ability to deal with such situations(Williams, 2017). Focusing on the case of the Federal Reserve, in the second principal section of the paper i briefly consider two proposed alternatives: (1) raising the Feds inflation target from its current level of 2 percent, and(2)introducing a price-level target. I argue that a higher inflation target has a number of important drawbacks: It would, obviously, lead to higher average inflation(possibly inconsistent with the Feds mandate for price stability); and, more subtly, it implies a Fed reaction function that theoretical analyses suggest is quite far from the optimal response. A price-level target performs better on both counts, as 1)it is fully consistent with the goal of price stability, perhap even more so than an inflation target; and 2)it implies a"lower-for-longer" response to periods when rates are at their ZlB, which approximates what theory tells us is the optimal approach However, a price-level target can be problematic in the face of supply shocks and the switch to a price-level target from the current inflation targeting approach would be a significant communications challenge. In the latter part of the section, I propose and discuss a third possible alternative: a temporary price-level target that kicks in only during periods in which rates are constrained by the ZlB. I argue that the adoption of a temporary price-level target would be likely to improve economic performance, relative to the current framework. Importantly, it would do that while both maintaining price stability and requiring only a relatively modest shift in the Feds framework and communication policies. However, this proposal is a tentative one at this stage, and more analysis would be needed before taking it further Beyond the problems arising from low nominal interest rates, monetary policymakers also face challenges to central bank independence(CBi). The challenge to CBI has been heightened by the political blowback that followed the financial crisis. But, as already noted, questions about CBI are also related to the change in the macroeconomic and interest-rate environment, linking this issue to the themes of the first part of the paper. In the United States the doctrine of CBI emerged, in part, from the inflationary experience of the 1960s and 1970s
3 will discuss, the depth and liquidity of the markets for U.S. government securities would make it difficult for the Fed to peg rates beyond a horizon of two years or so. Although unconventional tools can increase the potency of monetary policy, the ZLB is still likely to be a binding constraint on the monetary response to a downturn that is more serious, or which occurs when rates remain (like today) below neutral levels. A second broad response to the problem is to modify the overall policy framework, with the goal of enhancing monetary policymakers’ ability to deal with such situations (Williams, 2017). Focusing on the case of the Federal Reserve, in the second principal section of the paper I briefly consider two proposed alternatives: (1) raising the Fed’s inflation target from its current level of 2 percent, and (2) introducing a price-level target. I argue that a higher inflation target has a number of important drawbacks: It would, obviously, lead to higher average inflation (possibly inconsistent with the Fed’s mandate for price stability); and, more subtly, it implies a Fed reaction function that theoretical analyses suggest is quite far from the optimal response. A price-level target performs better on both counts, as 1) it is fully consistent with the goal of price stability, perhaps even more so than an inflation target; and 2) it implies a “lower-for-longer” response to periods when rates are at their ZLB, which approximates what theory tells us is the optimal approach. However, a price-level target can be problematic in the face of supply shocks, and the switch to a price-level target from the current inflation targeting approach would be a significant communications challenge. In the latter part of the section, I propose and discuss a third possible alternative: a “temporary price-level target” that kicks in only during periods in which rates are constrained by the ZLB. I argue that the adoption of a temporary price-level target would be likely to improve economic performance, relative to the current framework. Importantly, it would do that while both maintaining price stability and requiring only a relatively modest shift in the Fed’s framework and communication policies. However, this proposal is a tentative one at this stage, and more analysis would be needed before taking it further. Beyond the problems arising from low nominal interest rates, monetary policymakers also face challenges to central bank independence (CBI). The challenge to CBI has been heightened by the political blowback that followed the financial crisis. But, as already noted, questions about CBI are also related to the change in the macroeconomic and interest-rate environment, linking this issue to the themes of the first part of the paper. In the United States, the doctrine of CBI emerged, in part, from the inflationary experience of the 1960s and 1970s
which was blamed in part on undue political influence on monetary policymakers. Following these events, both formal models and informal conventional wisdom held that, to avoid pressures to overheat the economy and allow higher inflation, the Fed needed greater independence from politics. However, the inflation-centric rationale for CBI looks a bit outdated in a world in which inflation and nominal interest rates are too low, rather than too high; and in which politicians have criticized central banks for being too expansionary rather than not expansionary enough Indeed, the same logic that holds that CBI is necessary to avoid excess inflation can be turned on its head, to imply that CBi is a barrier to the fiscal-monetary coordination needed to combat deflation(Eggertsson, 2013) The last principal section of the paper briefly takes up these issues. I argue that the case for CBi has always been broader than the anti-inflationist argument, and that CBI should remain in place in the new economic environment. at the same time i contend that the case for cbi is instrumental, that it depends on costs and benefits rather than on philosophical principles, so that the limits of independence appropriately depend on the sphere of activity under consideration and on economic conditions. The general principle of CBI thus does not preclude coordination of central bank policies with other parts of the government in certain situations DEFEATING THE ZLB UNCONVENTIONAL POLICY TOOLS Central bankers in 2008 faced extraordinarily difficult challenges, in particular the combination of a deep recession-which made a sharp easing of monetary conditions necessary-and the proximity of short-term interest rates to zero, which made easing difficult In response, monetary policymakers employed a number of unconventional policy measures Which ones will become part of the standard toolbox? In what order or combination might the various tools of monetary policy be used in the future? In this section, I comment on these issues. I take as given that management of a short-term policy rate(e. g. the federal funds rate in the United States)will remain the primary tool, so long as the ZlB is not binding. I wont have much to say about the technicalities of monetary policy implementation(e. g, the distinction between a"floor" and"corridor" system for managing short-term rates), although unconventional policies(such as quantitative easing) can at times complicate implementation. I discuss, sequentially, forward guidance, quantitative easing, negative rates, and yield curve control(the management of longer-term yields)
4 which was blamed in part on undue political influence on monetary policymakers. Following these events, both formal models and informal conventional wisdom held that, to avoid pressures to overheat the economy and allow higher inflation, the Fed needed greater independence from politics. However, the inflation-centric rationale for CBI looks a bit outdated in a world in which inflation and nominal interest rates are too low, rather than too high; and in which politicians have criticized central banks for being too expansionary rather than not expansionary enough. Indeed, the same logic that holds that CBI is necessary to avoid excess inflation can be turned on its head, to imply that CBI is a barrier to the fiscal-monetary coordination needed to combat deflation (Eggertsson, 2013). The last principal section of the paper briefly takes up these issues. I argue that the case for CBI has always been broader than the anti-inflationist argument, and that CBI should remain in place in the new economic environment. At the same time, I contend that the case for CBI is instrumental, that it depends on costs and benefits rather than on philosophical principles, so that the limits of independence appropriately depend on the sphere of activity under consideration and on economic conditions. The general principle of CBI thus does not preclude coordination of central bank policies with other parts of the government in certain situations. DEFEATING THE ZLB: UNCONVENTIONAL POLICY TOOLS Central bankers in 2008 faced extraordinarily difficult challenges, in particular the combination of a deep recession—which made a sharp easing of monetary conditions necessary—and the proximity of short-term interest rates to zero, which made easing difficult. In response, monetary policymakers employed a number of unconventional policy measures. Which ones will become part of the standard toolbox? In what order or combination might the various tools of monetary policy be used in the future? In this section, I comment on these issues. I take as given that management of a short-term policy rate (e.g., the federal funds rate in the United States) will remain the primary tool, so long as the ZLB is not binding. I won’t have much to say about the technicalities of monetary policy implementation (e.g., the distinction between a “floor” and “corridor” system for managing short-term rates), although unconventional policies (such as quantitative easing) can at times complicate implementation. I discuss, sequentially, forward guidance, quantitative easing, negative rates, and yield curve control (the management of longer-term yields)
Forward guidance The non-standard tool on which central bankers are most likely to rely in the next easing cycle is forward guidance, or communication about the expected or intended future path of the policy rate. The Fed used variants of forward guidance in the Greenspan era, for example, in references to keeping rates low for a considerable period"(Federal Open Market Committee 2003). Even earlier, a number of central banks experimented with forward-looking policy commitments, a notable case being the Bank of Japan's zero-interest-rate policy (ZiRP), in which the boj said that it would not lift rates from zero until certain conditions had been met (Bank of Japan, 1999). The prices of longer-term financial assets(including those most closely tied to economic activity, such as corporate bonds, mortgages, and stocks)depend on not only the current setting of the policy rate but on its entire expected future path. Consequently, central bank"open-mouth operations" that influence market expectations of future policies can affect financial conditions today, even if the short-term policy rate is close to its effective lower bound Guthrie and Wright, 2000) Forward guidance comes in a number of forms. A useful distinction is between Delphi and Odyssean forward guidance( Campbell et al., 2012). Delphic guidance is a simple statement of how monetary policymakers see the economy and interest rates as likely to evolve. Delphic guidance is advisory only and makes no promises about future policy. In contrast, Odyssean guidance-the phrase is motivated by Odysseus's decision to tie himself to the mast to be able to resist the calls of the Sirens--is intended to pre-commit the central bank to some(possibly contingent) set of future policies The goals of Delphic and Odyssean guidance are different. Delphic guidance-as for example seen in the Fed's famous dot plot, which shows the interest-rate forecasts of individual FOMC participants--is designed primarily to help the public and market participants understand the committee's outlook, reaction function, and policy plans. More informally central bankers' public remarks about the likely course of the economy and policy are usuall Delphic in intent. Increasingly, central banks are incorporating Delphic guidance into their communication strategy during normal times this development primarily reflects trends to increased transparency by central banks, rather than the emergence of the Zlb as an important
5 Forward guidance The non-standard tool on which central bankers are most likely to rely in the next easing cycle is forward guidance, or communication about the expected or intended future path of the policy rate. The Fed used variants of forward guidance in the Greenspan era, for example, in references to keeping rates low for “a considerable period” (Federal Open Market Committee, 2003). Even earlier, a number of central banks experimented with forward-looking policy commitments, a notable case being the Bank of Japan’s zero-interest-rate policy (ZIRP), in which the BOJ said that it would not lift rates from zero until certain conditions had been met (Bank of Japan, 1999). The prices of longer-term financial assets (including those most closely tied to economic activity, such as corporate bonds, mortgages, and stocks) depend on not only the current setting of the policy rate but on its entire expected future path. Consequently, central bank “open-mouth operations” that influence market expectations of future policies can affect financial conditions today, even if the short-term policy rate is close to its effective lower bound (Guthrie and Wright, 2000). Forward guidance comes in a number of forms. A useful distinction is between Delphic and Odyssean forward guidance (Campbell et al., 2012). Delphic guidance is a simple statement of how monetary policymakers see the economy and interest rates as likely to evolve. Delphic guidance is advisory only and makes no promises about future policy. In contrast, Odyssean guidance—the phrase is motivated by Odysseus’s decision to tie himself to the mast to be able to resist the calls of the Sirens—is intended to pre-commit the central bank to some (possibly contingent) set of future policies. The goals of Delphic and Odyssean guidance are different. Delphic guidance—as for example seen in the Fed’s famous “dot plot,” which shows the interest-rate forecasts of individual FOMC participants—is designed primarily to help the public and market participants understand the committee’s outlook, reaction function, and policy plans. More informally, central bankers’ public remarks about the likely course of the economy and policy are usually Delphic in intent. Increasingly, central banks are incorporating Delphic guidance into their communication strategy during normal times; this development primarily reflects trends to increased transparency by central banks, rather than the emergence of the ZLB as an important
policy constraint. By improving the clarity of the central bank communication, Delphic guidance is intended to increase the predictability of monetary policy and make it more effective Odyssean guidance, in contrast, is most likely to be relevant when the policy rate is at or close to the ZlB, so that the scope for short-term rate cuts is limited. Typically, monetary policymakers use Odyssean guidance to communicate a promise to keep rates lower for longer than implied by their"normal"reaction function. If the promise is credible, then market participants should bid down longer-term yields and bid up asset prices today, effectively adding stimulus despite the ZlB constraint. The key word here is"commitment. "If prior commItment were impossible, for the reasons explored in the time-consistency literature( Kydland and Prescott, 1977), then Odyssean forward guidance could not materially change market expectations and would consequently be useless. In practice, central bank guidance does appear to have significant effects on asset prices(Campbell et al., 2012; Swanson, 2017)and thus, presumably, on the economy. Central bankers concerns for their own reputations and those of their institutions, as well as the tendency of market participants to look for focal points around which expectations can coalesce, appear in practice to provide monetary policymakers some ability to commit to future policy actions The Federal Open Market Committee(FOMC), the Fed's policymaking body, provided regular forward guidance during the recovery from the crisis. Some controversy has arisen about the FOMC's approach. Michael Woodford (2009)and others have argued that the FOMC inappropriately used Delphic rather than Odyssean formulations in its guidance, limiting its enefit. For example, at the same meeting at which the policy rate was cut effectively to zero the december 2008 FOMC statement indicated, ". the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time"(FOMC, 2008 ). By speaking of anticipating" or"expecting " rates to remain low, rather than using stronger language of commitment or intention, Woodford argues, the FOMC created less stimulus than it might have. Indeed, by signaling pessimism about the outlook, the FOMC's guidance(in Woodfords view)might have been counterproductive Woodford is right in principle, and all else equal, a policy committee whose intent is to provide odyssean guidance should try to make its commitments as clear and as nearly ironclad as possible. A real-world complication is that policy committees are not typically unitary actors but may include participants of diverse views, trying to reach compromise in an uncertain
6 policy constraint. By improving the clarity of the central bank communication, Delphic guidance is intended to increase the predictability of monetary policy and make it more effective. Odyssean guidance, in contrast, is most likely to be relevant when the policy rate is at or close to the ZLB, so that the scope for short-term rate cuts is limited. Typically, monetary policymakers use Odyssean guidance to communicate a promise to keep rates lower for longer than implied by their “normal” reaction function. If the promise is credible, then market participants should bid down longer-term yields and bid up asset prices today, effectively adding stimulus despite the ZLB constraint. The key word here is “commitment.” If prior commitment were impossible, for the reasons explored in the time-consistency literature (Kydland and Prescott, 1977), then Odyssean forward guidance could not materially change market expectations and would consequently be useless. In practice, central bank guidance does appear to have significant effects on asset prices (Campbell et al., 2012; Swanson, 2017) and thus, presumably, on the economy. Central bankers’ concerns for their own reputations and those of their institutions, as well as the tendency of market participants to look for focal points around which expectations can coalesce, appear in practice to provide monetary policymakers some ability to commit to future policy actions. The Federal Open Market Committee (FOMC), the Fed’s policymaking body, provided regular forward guidance during the recovery from the crisis. Some controversy has arisen about the FOMC’s approach. Michael Woodford (2009) and others have argued that the FOMC inappropriately used Delphic rather than Odyssean formulations in its guidance, limiting its benefit. For example, at the same meeting at which the policy rate was cut effectively to zero, the December 2008 FOMC statement indicated, “…the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time” (FOMC, 2008). By speaking of “anticipating” or “expecting” rates to remain low, rather than using stronger language of commitment or intention, Woodford argues, the FOMC created less stimulus than it might have. Indeed, by signaling pessimism about the outlook, the FOMC’s guidance (in Woodford’s view) might have been counterproductive. Woodford is right in principle, and all else equal, a policy committee whose intent is to provide Odyssean guidance should try to make its commitments as clear and as nearly ironclad as possible. A real-world complication is that policy committees are not typically unitary actors, but may include participants of diverse views, trying to reach compromise in an uncertain
environment. Some hedging or ambiguity in the committees official statements may therefore be difficult to avoid. In practice, however, the FOMC s guidance after the crisis-as mediated by the public comments of policymakers-did seem to have Odyssean effects. Notably, the Feds introduction of forward guidance was typically followed by changes in longer-term interest rates, exchange rates, and equity prices consistent with substantial increases in monetary accommodation(Femia et al., 2013; Swanson, 2017) and by reduced sensitivity of near-term rate expectations to economic news(williams, 2014). The increases in equity prices in particular suggested that markets were focused on the FOMC's signal of greater policy patience(the Odyssean aspect)rather than on an indication of greater pessimism delphic). moreover professional forecasters reacted to FOMC guidance by repeatedly marking down the unemployment rate they expected to prevail at the time that the Committee began to lift the funds rate away from zero, implying a perceived shift in the Fed's expected reaction function (Bernanke, 2012; Femia et al., 2013). The apparent success of the FOMC's guidance, developee on the fly, is promising for the future use of verbal interventions. As both central bankers and market participants gain experience with forward guidance, the tool should become increasingly effective Another important distinction is between qualitative guidance("considerable period) and quantitative guidance, for example, describing specific economic conditions that would lead to a change in policy. Over the years, Fed guidance has evolved from qualitative towards quantitative, reflecting the desire to enhance transparency as well as the imperative of adding substantial accommodation during the ZlB period. Economic logic suggests that quantitative guidance will be more effective, because it is both more precise and more verifiable ex post(and thus easier to support by reputational concerns). However, again, a policy committee may not al ways be able to agree on quantitative guidance. It may also be the case that uncertainty about the economic situation favors the relative ambiguity of a qualitative formulation, at least initially Experience suggest though that qualitative guidance, if maintained for a while, often morphs into quantitative guidance, as market participants, legislative committees, and other stakeholders press policymakers to clarify the meaning of key phrases Yet another dimension of forward guidance is time-dependency versus state-dependency The FOMC used both types after the crisis, indicating first that it expected to hold rates low through a certain date, then tying rate increases to thresholds based on the prevailing
7 environment. Some hedging or ambiguity in the committee’s official statements may therefore be difficult to avoid. In practice, however, the FOMC’s guidance after the crisis—as mediated by the public comments of policymakers—did seem to have Odyssean effects. Notably, the Fed’s introduction of forward guidance was typically followed by changes in longer-term interest rates, exchange rates, and equity prices consistent with substantial increases in monetary accommodation (Femia et al., 2013; Swanson, 2017) and by reduced sensitivity of near-term rate expectations to economic news (Williams, 2014). The increases in equity prices in particular suggested that markets were focused on the FOMC’s signal of greater policy patience (the Odyssean aspect) rather than on an indication of greater pessimism (Delphic). Moreover, professional forecasters reacted to FOMC guidance by repeatedly marking down the unemployment rate they expected to prevail at the time that the Committee began to lift the funds rate away from zero, implying a perceived shift in the Fed’s expected reaction function (Bernanke, 2012; Femia et al., 2013). The apparent success of the FOMC’s guidance, developed on the fly, is promising for the future use of verbal interventions. As both central bankers and market participants gain experience with forward guidance, the tool should become increasingly effective. Another important distinction is between qualitative guidance (“considerable period”) and quantitative guidance, for example, describing specific economic conditions that would lead to a change in policy. Over the years, Fed guidance has evolved from qualitative towards quantitative, reflecting the desire to enhance transparency as well as the imperative of adding substantial accommodation during the ZLB period. Economic logic suggests that quantitative guidance will be more effective, because it is both more precise and more verifiable ex post (and thus easier to support by reputational concerns). However, again, a policy committee may not always be able to agree on quantitative guidance. It may also be the case that uncertainty about the economic situation favors the relative ambiguity of a qualitative formulation, at least initially. Experience suggest though that qualitative guidance, if maintained for a while, often morphs into quantitative guidance, as market participants, legislative committees, and other stakeholders press policymakers to clarify the meaning of key phrases. Yet another dimension of forward guidance is time-dependency versus state-dependency. The FOMC used both types after the crisis, indicating first that it expected to hold rates low through a certain date, then tying rate increases to thresholds based on the prevailing
unemployment and inflation rates. In principle, policy settings should depend on the state of the economy, and so state-dependent guidance should be the default in the future(Feroli et al 2016). As pointed out by williams(2016)however, date-based guidance may at times be more effective, perhaps because it is more definitive and more credible to market participants. A particular situation in which date-based guidance might be desirable arises when policymakers and the market have different economic outlooks. Suppose the ideal guidance would hold rates at zero at least until unemployment fell to 6 percent; but suppose also that market participants expect unemployment to reach 6 percent in one year while policymakers believe that unemployment will decline more slowly, reaching 6 percent in two years. In that case, state dependent guidance would be insufficiently stimulative from the policymakers point of view a greater reduction in current long-term rates and be more consistent with the policymakeo'To and time-dependent guidance(a promise that rates will remain low for two years)would achie I've been discussing forward guidance about rates, but guidance can be provided about aspects of policy other than rates, notably, about plans for asset purchases. Such guic a natural extension of rate guidance and can be Delphic or Odyssean in intent. The main point here is that guidance about the components of policy needs to be carefully coordinated, so that the planned sequencing of policy changes is clear. For example, the famous 2013 taper tantrum"followed Fed guidance that it anticipated reducing the pace of its asset purchases, conditional on economic developments. However, the tantrum reflected not so much the expectation of reduced asset purchases per se, but rather the inference in some quarters of the market(as could be seen in futures quotes) that increases in short-term rates would quickly follow the slowing of asset purchases. (See below for more on the"signaling?"aspects of quantitative easing. Fed policymakers had communicated their intention to keep rates low for a long time after the end of asset purchases, but evidently those promises had not sunk in, and The FOMC experimented with three variations of qualitative forward guidance in December 2008, March 2009 and November 2009. In August 2011, January 2012 and September 2012, the FOMC used different versions of calendar-based forward guidance in which they set a date in which they would keep rates'exceptionally low.In December 2012 the FOMC switched to a state-dependent form of forward guidance in which they committed to keeping interest rates 'exceptionally low at least as long as the unemployment rate was above 6.5%, inflation was below 2.5% based on one to two year ahead forecasts, and inflation expectations remained anchored s In principle, optimal policy depends not only on the current state of the economy but on its history as well. I discuss this point further below
8 unemployment and inflation rates.2 In principle, policy settings should depend on the state of the economy, and so state-dependent guidance should be the default in the future (Feroli et al., 2016).3 As pointed out by Williams (2016) however, date-based guidance may at times be more effective, perhaps because it is more definitive and more credible to market participants. A particular situation in which date-based guidance might be desirable arises when policymakers and the market have different economic outlooks. Suppose the ideal guidance would hold rates at zero at least until unemployment fell to 6 percent; but suppose also that market participants expect unemployment to reach 6 percent in one year while policymakers believe that unemployment will decline more slowly, reaching 6 percent in two years. In that case, statedependent guidance would be insufficiently stimulative from the policymakers’ point of view, and time-dependent guidance (a promise that rates will remain low for two years) would achieve a greater reduction in current long-term rates and be more consistent with the policymakers’ objectives. I’ve been discussing forward guidance about rates, but guidance can be provided about aspects of policy other than rates, notably, about plans for asset purchases. Such guidance is a natural extension of rate guidance and can be Delphic or Odyssean in intent. The main point here is that guidance about the components of policy needs to be carefully coordinated, so that the planned sequencing of policy changes is clear. For example, the famous 2013 “taper tantrum” followed Fed guidance that it anticipated reducing the pace of its asset purchases, conditional on economic developments. However, the tantrum reflected not so much the expectation of reduced asset purchases per se, but rather the inference in some quarters of the market (as could be seen in futures quotes) that increases in short-term rates would quickly follow the slowing of asset purchases. (See below for more on the “signaling” aspects of quantitative easing.) Fed policymakers had communicated their intention to keep rates low for a long time after the end of asset purchases, but evidently those promises had not sunk in, and 2 The FOMC experimented with three variations of qualitative forward guidance in December 2008, March 2009, and November 2009. In August 2011, January 2012 and September 2012, the FOMC used different versions of calendar-based forward guidance in which they set a date in which they would keep rates ‘exceptionally low’. In December 2012 the FOMC switched to a state-dependent form of forward guidance in which they committed to keeping interest rates ‘exceptionally low’ at least as long as the unemployment rate was above 6.5%, inflation was below 2.5% based on one to two year ahead forecasts, and inflation expectations remained anchored. 3 In principle, optimal policy depends not only on the current state of the economy but on its history as well. I discuss this point further below
coordinated reiterations of the point had to be made before market expectations re-adjusted and market conditions calmed A final observation on forward guidance: In this section I have been treating guidance, particularly of the Odyssean variety, as an ad hoc intervention, a supplement to management of the short-term rate. Alternatively, or in addition, the central bank could adopt an overarching framework that implies systematic Odyssean responses to ZLB episodes. I'll explore this possibility below, in the section on policy frameworks Q uantitative easing Probably the most controversial form of unconventional policy adopted in recent years was what the Federal Reserve called large-scale asset purchases (LSAPs) but most of the rest of the world persisted in calling"quantitative easing,", or QE. The Federal Reserve engaged in three rounds of Qe, during which its balance sheet expanded from less than a trillion dollars to $4.5 trillion. The Bank of England, European Central Bank, Swedish Riksbank, and Bank of Japan(which had pioneered asset purchases as a form of monetary policy well before the crisis) have also undertaken quantitative easin Quantitative easing involves central bank purchases of securities in the open market, financed by the creation of bank reserves held at the central bank. By law, the Fed was able to purchase only Treasury securities and mortgage-related securities issued by government- sponsored enterprises. Other central banks, in contrast, have been able to buy a range of private securities, including corporate bonds and equities. The limits on the Fed did not seem to prevent its version of QE from being effective, although it was perhaps fortunate that, following a crisis centered on housing finance, the law did permit Fed purchases of mortgage-related securities Research suggests that QE works through two principal channels, the signaling channel and the portfolio balance channel. The signaling channel arises to the extent that asset purchases serve to demonstrate the central banks commitment to monetary easing, and in particular to keeping short-term rates lower for longer(Bauer and Rudebusch, 2013). As discussed above, the sO-called taper tantrum in 2013 demonstrated the practical relevance of the signaling channel of I also tried, without success, to name the program"credit easing, to distinguish it from the Bank of Japan's earlier foray into asset purchases(Bernanke, 2009). I argued that"credit easing focused on removing duration from bond markets, in contrast to BOJ-style quantitative easing, which had the primary goal and metric of increasing the high wered money stock
9 coordinated reiterations of the point had to be made before market expectations re-adjusted and market conditions calmed. A final observation on forward guidance: In this section I have been treating guidance, particularly of the Odyssean variety, as an ad hoc intervention, a supplement to management of the short-term rate. Alternatively, or in addition, the central bank could adopt an overarching framework that implies systematic Odyssean responses to ZLB episodes. I’ll explore this possibility below, in the section on policy frameworks. Quantitative easing Probably the most controversial form of unconventional policy adopted in recent years was what the Federal Reserve called large-scale asset purchases (LSAPs) but most of the rest of the world persisted in calling “quantitative easing”, or QE.4 The Federal Reserve engaged in three rounds of QE, during which its balance sheet expanded from less than a trillion dollars to $4.5 trillion. The Bank of England, European Central Bank, Swedish Riksbank, and Bank of Japan (which had pioneered asset purchases as a form of monetary policy well before the crisis) have also undertaken quantitative easing. Quantitative easing involves central bank purchases of securities in the open market, financed by the creation of bank reserves held at the central bank. By law, the Fed was able to purchase only Treasury securities and mortgage-related securities issued by governmentsponsored enterprises. Other central banks, in contrast, have been able to buy a range of private securities, including corporate bonds and equities. The limits on the Fed did not seem to prevent its version of QE from being effective, although it was perhaps fortunate that, following a crisis centered on housing finance, the law did permit Fed purchases of mortgage-related securities. Research suggests that QE works through two principal channels, the signaling channel and the portfolio balance channel. The signaling channel arises to the extent that asset purchases serve to demonstrate the central bank’s commitment to monetary easing, and in particular to keeping short-term rates lower for longer (Bauer and Rudebusch, 2013). As discussed above, the so-called taper tantrum in 2013 demonstrated the practical relevance of the signaling channel of 4 I also tried, without success, to name the program “credit easing,” to distinguish it from the Bank of Japan’s earlier foray into asset purchases (Bernanke, 2009). I argued that “credit easing” focused on removing duration from bond markets, in contrast to BOJ-style quantitative easing, which had the primary goal and metric of increasing the highpowered money stock