Wednesday, January 4, 2012

The Fed and Forward Guidance

The news from the December 13 FOMC minutes is in the very last part, following the policy decision, and relates to "forward guidance," i.e. information that comes from the FOMC about the future path for policy instruments. Here's the relevant passage in the minutes:
After the Committee's vote, participants turned to a further consideration of ways in which the Committee might enhance the clarity and transparency of its public communications. The subcommittee on communications recommended an approach for incorporating information about participants' projections of appropriate future monetary policy into the Summary of Economic Projections (SEP), which the FOMC releases four times each year. In the SEP, participants' projections for economic growth, unemployment, and inflation are conditioned on their individual assessments of the path of monetary policy that is most likely to be consistent with the Federal Reserve's statutory mandate to promote maximum employment and price stability, but information about those assessments has not been included in the SEP.

A staff briefing described the details of the subcommittee's recommended approach and compared it with those taken by several other central banks. Most participants agreed that adding their projections of the target federal funds rate to the economic projections already provided in the SEP would help the public better understand the Committee's monetary policy decisions and the ways in which those decisions depend on members' assessments of economic and financial conditions. One participant suggested that the economic projections would be more understandable if they were based on a common interest rate path. Another suggested that it would be preferable to publish a consensus policy projection of the entire Committee. Some participants expressed concern that publishing information about participants' individual policy projections could confuse the public; for example, they saw an appreciable risk that the public could mistakenly interpret participants' projections of the target federal funds rate as signaling the Committee's intention to follow a specific policy path rather than as indicating members' conditional projections for the federal funds rate given their expectations regarding future economic developments. Most participants viewed these concerns as manageable; several noted that participants would have opportunities to explain their projections and policy views in speeches and other forms of communication. Nonetheless, some participants did not see providing policy projections as a useful step at this time.

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. An accompanying narrative will describe the key factors underlying those assessments as well as qualitative information regarding participants' expectations for the Federal Reserve's balance sheet. A number of participants suggested further enhancements to the SEP; the Chairman asked the subcommittee to explore such enhancements over coming months.

Following up on the Committee's discussion of policy frameworks at its November meeting, the subcommittee on communications presented a draft statement of the Committee's longer-run goals and policy strategy. Participants generally agreed that issuing such a statement could be helpful in enhancing the transparency and accountability of monetary policy and in facilitating well-informed decisionmaking by households and businesses, and thus in enhancing the Committee's ability to promote the goals specified in its statutory mandate in the face of significant economic disturbances. However, a couple of participants expressed the concern that a statement that was sufficiently nuanced to capture the diversity of views on the Committee might not, in fact, enhance public understanding of the Committee's actions and intentions. Participants commented on the draft statement, and the Chairman encouraged the subcommittee to make adjustments to the draft and to present a revised version for the Committee's further consideration in January.
The FOMC statement has, since August 2011, contained this language:
The Committee also decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions--including low rates of resource utilization and a subdued outlook for inflation over the medium run--are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013.
The last few words are the forward guidance, i.e. barring some unforeseen dramatic events, the policy rate will not change until mid-2013. Given the failure of the recovery from the recession to proceed as quickly as anticipated, the Fed is under intense pressure from some quarters to do something more than what it has already done, which includes: (i) lowering the interest rate on reserves (now the key policy rate) to 0.25%, where it has been since October 2008; (ii) purchasing large quantities of mortgage-backed securities, agency securities, and long-term Treasury securities, resulting in a more-than-tripling in the size of the Fed's balance sheet. The idea behind forward guidance is that anticipated Fed policy actions are important for economic activity; if anything they are more important than what we actually see the Fed doing today. Such anticipated future monetary policy actions are critical for how consumers and businesses make decisions about borrowing and lending in credit markets, and those decisions are critical for the economic recovery.

Recall that the type of forward guidance in the current FOMC statement was the subject of some controversy in August 2011. Fisher, Kocherlakota, and Plosser dissented from the original FOMC decision, in part because they thought this was inappropriate forward guidance - essentially the wrong kind of commitment. Since August 2011, other FOMC members have apparently been thinking about other kinds of forward guidance, with Charles Evans being perhaps the most vociferous. He would apparently have liked to have seen specific language in the FOMC statement making future policy actions specifically contingent on the unemployment rate and the inflation rate.

What was actually adopted seems a compromise. The FOMC will now include information in its Summary of Economic Projections about the future Fed policy that actually goes into the forecasts. As I understand it, The Summary of Economic Projections represents some averaging across forecasts made by each regional Federal Reserve Bank and by the staff at the Board of Governors in Washington. When for example the Federal Reserve Bank of Boston staff do a forecast, part of the forecast has to be the future path for the Fed's policy rate, and perhaps the future paths of some items on the Fed's balance sheet, if those things are in the model the Boston Fed is using. I'm not sure how they do that, as I have never been in on one of these exercises. Maybe they simply fix a future path for the fed funds rate, and then make the forecast conditional on that. Maybe their model contains an estimated policy rule, and then part of the forecasting exercise involves tweaking that rule with add factors to produce a forecast that the forecasters feel comfortable with. For the Boston Fed, the latter would be the sensible procedure, one would think.

So, what we will now see, instead of this summary of economic projections is one that includes some averaging of forecasts for future Fed policy. What do you think this will communicate to us? For anyone who wants the information, and is willing to pay for it, Macroeconomic Advisers, for example, can probably forecast the behavior of the Fed as well as the Fed can forecast itself. So given that you care about these things, you already subscribe to Macro Advisers, and the extra information from the Fed has close to zero value. For the rest of the general public, the Summary of Economic Projections is almost certainly not on your radar screen. Maybe the information could be filtered through the media in a reasonable way, but the result might just be an increase in confusion. More information is not always better.

Addendum: I ran across this speech by Charles Plosser which perhaps makes clearer what the FOMC has in mind here. Plosser says:
The Summary of Economic Projections provides a better and more natural way to convey the Committee’s sense of the future path of policy. Currently, the SEP indicates individual policymakers’ forecasts of the key economic variables, including output, inflation, and unemployment conditional on each policymaker’s assessment of “appropriate policy” in the absence of further shocks. I think a more appropriate and meaningful way for the Committee to convey forward guidance would be to report information about Committee members’ underlying view of “appropriate policy.” This additional information would provide a useful picture of the range of views of future policy as envisioned by the policymakers. These views would not constitute a commitment to follow a particular path but would evolve as economic conditions changed. This information would add a useful signal to the markets as to the thinking of the Committee on an ongoing basis.
Plosser hopes that people will understand that the extra information included in the SEP is there just to reveal "the thinking of the Committee," and will not be interpreted as a solid commitment. People do get confused, though.


  1. The public is entitled to transparency, clarity and commitment.

    The Fed fails on all counts. They may tell where the rudder is, but never the destination. They think mumbling is clever. Most likely, they think some institutional mysticism will impress the laity.

    The Fed should announce growth targets for Nominal GDP, and the mechanism they will use to get there.

    BTW, look at the money supply numbers generated by something called "Divisia." Woolsey at Monetary Freedom.

    Fed to US Economy: Drop Dead. We are are passively tightening the monetary noose while in the Great Recession.

    Honestly, I would say most of the economic profession is not only barking up the wrong tree, but in the wrong forest.

  2. The FED can't forecast. Without countervailing stimulus monetary flows MVt will collapse in the MAY thru JUNE time period. That said, QE3 is a given.