Roll your own FOMC forward guidance (US Central Bank Policy)

Great Debates
#1

Re: Today’s release of FOMC forward guidance, little changed since last month IIRC.

You have just been appointed Chairman of the US Federal Open Market Committee with your 11 clones making up the remainder of its membership. Congratulations! The first meeting convenes in March. Today we are discussing the release of the Jan 29, 2014 FOMC statement, the last one of your predecessors. The section on forward guidance follows:

I broke up the paragraph. Topics for discussion:

  1. Would would be your preferred language? Or are you happy with it now? If you want dramatically different language, I would recommend you pen 2 different statements, one more plausible and the other more pie in the sky. In other words if you want to advocate GDP level targeting, it might be interesting to also present a less ambitious proposal.

  2. What do you think would be effects of your policy, relative to what has been put forth today?

I’ll start.

The Committee of one also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be [del]no more than a half percentage point above the Committee’s 2 percent longer-run goal[/del] less than 4%, and longer-term inflation expectations continue to be well anchored. … The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run [del]below[/del] outside the Committee’s [del]2 percent longer-run goal of[/del] 2.5 to 4 percent comfort zone. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of [del]2 percent[/del] 2.5 to 4.0 percent. I don’t have a more ambitious proposal.

We’ve had a number of deflation scares since 2000. Keeping inflation above 2.5% leaves room for adverse shocks. It also makes monetary policy more effective as a 0.25 percent nominal rate translates into a lower-inflation adjusted interest rate. (CPI inflation is running at 1.5%; core CPI is 1.7%; the PCE deflator is at 0.9%, while the core PCE is at 1.8%). Finally, the existence of nominal wage rigidities implies that a little inflation can aid the labor adjustment process. Labor productivity can decline in a firm for all manner of reasons, some outside the control of the individual worker. Small levels of inflation can permit mild inflation-adjusted wage cuts with less drama.

What would be the effects of my recommendation? I can think of 3 possibilities.

a) Faced with higher anticipated price increases, businesses invest more and consumers purchase durables now. Thus the economy is stimulated. Three year bond rates fall, though 30 year bond rates might rise.

b) Worst case scenario. The bond market pays attention to the Fed while Main Street (and corporate investment planners) ignores it. So bond yields rise, ironically depressing the economy. Later, presumably, they might fall as softness in the economy becomes more apparent. At any rate announcement of such targets makes them less likely to be achieved. Yes the irony is staggering.

c) Nobody believes the Fed, at least insofar as their individual economic behavior is concerned. So forward guidance doesn’t matter too much. Fed watchers still keep their jobs though.

I think (a) is most likely of the 3 though I don’t know how much additional stimulus would be delivered. And the proper answer I think is we don’t know. Forward guidance doesn’t have a sufficient track record to make a judgment, 2013 notwithstanding. But, hey, maybe someone will write a clever paper on the subject within the next few years.

Also, I might want to propose a central inflation target. If so, it’s 3%. Arguably, it and my so-called comfort zone should be higher.

#2

NGDP level targeting.

NGDP level targeting.

NGDP level targeting.

NGDP level targeting.

NGDP level targeting.

A 2.5% inflation goal.

Level targeting. Making it the level from 2008 would temporarily give a higher target until we were back on the previous trend line.

It’d also be beneficial to follow the Lars Svennson approach (former deputy governor of the Bank of Sweden) to target the central bank’s own forecast. In other words, if their forecast states that their current policy will fall a half point short of their ostensible goal, then obviously they’re following the wrong damn policy. They need to do more until their action has been sufficient to change their own forecast. I would also announce the creation of a new NGDP futures market. In an ideal world, the entire process could be rules-based and not discretionary, but I’m just not that trusting. I would not make policy dependent on that market. Too much potential for abuse by unscrupulous interests. Still, it’s be nice to have an explicit market estimate for the expected flow of money over the next year.

#3

Hear, hear!
Um, core inflation or headline CPI? Or core PCE?

ETA: Oh yeah, and what’s the target NGDP growth for the US and Australia if you have that handy?

#4

Headline CPI.

You can see the performance of the Bank of Canada. Some people say their success in hitting their target so precisely is just luck. This is despite the fact that Canada’s inflation was both much higher and more volatile before their announcement of a strict target. A central bank has extraordinary influence on the big nominal variables.

Australia and the US don’t have NGDP targets. Australia targets an inflation band of between two and three percent, and currently the US has a mixture of various things like the unemployment rate and inflation to guide their policy.

Or do you mean recommended policy? I’d want to study Australia more before I said anything. The US should have an NGDP growth target of between 4 and 5 percent. We’re getting to the point where it wouldn’t be helpful to start the level targeting from the past, and it would be fine to start the target in growth from the present trend line. But they need to get on the ball with this. Economies have hiccups. Eventually the US will hit a bump, and we’ll be right up against that interest rate lower-bound again, and without a better target, we can get mired in that previous malaise rather than continuing the recovery.

The is the single most important thing Janet Yellen has in front of her. It’s not enough to continue Bernanke’s policies out of the past mess. She needs to set up a more robust policy of guidance to better ensure a proper response to any future messes. The one good thing is that NGDP is no longer being ignored like it was in 2008. People have got their eyes fixed firmly on it. If forecasts of growth start to tumble again, then the business media will report the hell out of it. That might make a big difference.