Ben Bernanke has been very focused on the Fed’s “communications strategy” for several years now, and has patiently pushed the FOMC in his desired direction during a series of detailed discussions. Now it seems that he has reached his destination, and will reveal all (or almost all) in his press conference after the FOMC meeting which begins on Tuesday. Always a fan of explicit inflation targets, the chairman seems finally to have won agreement from colleagues on establishing a formal objective for core inflation of about 2 per cent, though the FOMC will also need to keep Congress happy by talking about its long term unemployment objectives as well. More unconventionally, each member of the FOMC will also publish for the first time their projections for the Fed funds rate extending to 2016.
What is the motivation behind these changes? Mr Bernanke has normally justified such steps in terms of stabilising expectations about the Fed’s genuine intentions, especially on inflation and the forward path for interest rates. At a time when the extension of the balance sheet is causing political difficulties for the Fed, and when inflation expectations could become unhinged by the rapid expansion of the monetary base, the chairman is looking for alternative ways of easing monetary conditions without printing more money. Modern macro-economics suggests that operating on expectations is one of the most powerful tools available to him, though he is using it much more cautiously than many economists would like to see.
The detailed format which the Fed will use this week to publish its forecasts for short rates is well explained by the FT Money Supply’s Robin Harding and by Phil Izzo at the Wall Street Journal. The key point is that the Fed chairman will want to persuade the market that short rates are likely to remain at zero for at least as long as the yield curve currently implies, and longer than stated in the Fed’s previous guidance up to mid 2013. Otherwise, this new piece of Fed transparency would back-fire by leading to a tightening in monetary conditions.
Although there are four hawks on the FOMC (Lacker, Plosser, Kocherlakota and Fisher) who may expect to see short rates rising fairly soon, the impact of this news should be swamped by the number of FOMC members who do not see rates as likely to rise until the end of 2014 or even later. Troy Davig at Barcap has published a neat piece of work which estimates the FOMC’s likely short rate projections from the Summary of Economic Projections (SEP) already published by the committee. He does this by using a fairly dovish version of the Taylor Rule to translate the FOMC’s inflation and unemployment projections into a path for short rates:
The upshot of this work is that the short rate forecasts are likely to be at least as dovish as the market currently expects, which is exactly what the chairman probably wants to achieve. (Note that other, more hawkish, versions of the Taylor Rule would result in an earlier tightening in policy, but these versions are not favoured by the majority of the committee.)
Longer term, the new mechanism will provide the Fed with a potentially important tool to influence expectations, and therefore the course of the economy. Paul Krugman was the first to argue in the 1990s that, in the modern version of the liquidity trap, an economy could get stuck permanently with high unemployment because of undesirable expectations of deflation. With short rates not able to drop below zero, the real rate of interest could be too high to equilibrate savings and investment in the economy, so the normal monetary route back to lower unemployment might be blocked. The answer, said Krugman, was for the central bank deliberately to increase the expected rate of inflation, and therefore to cut the real rate of interest while nominal short rates were fixed at zero.
Since the late 1990s, this insight has been refined by Michael Woodford and Gauti Eggertsson (2003 and 2006) among many others, but the the principle remains the same. If the Fed is able to persuade the private sector that it will pursue a course of rising prices after the economy has fully recovered, then forward looking agents will increase their investment spending today, pulling the economy out of the liquidity trap. More recently, it has been shown that if the Fed were able to make a credible commitment to keep short rates at zero for a period after inflation starts to rise, it would have the equivalent effect. (See, for example, the graphs on page 259 from Eggertsson, 2011.)
Ben Bernanke comes from the broadly same intellectual stable as these authors, and in any case they probably represent fairly accurately what the bulk of the macro-economics profession, excluding the Chicago school, believes to be “best practice” at present. The problem for practitioners, however, is the time inconsistency of these proposals. It is one thing to promise now to hold interest rates at zero if inflation starts to rise in several years time, and quite another actually to do that in the circumstances of the time.
The temptation to renege on a long forgotten commitment, possibly made by an earlier Fed chairman under a previous administration, would surely be overwhelming once the economy is recovering. Since the private sector knows in advance that this would be the case, it would be extremely hard to persuade people today that such a policy would in fact be pursued in the future. And that would defeat its purpose.
I am not aware of any solid answer to that Catch 22. Furthermore, there is a lot of evidence that the Fed is unwilling to take any risks with inflation expectations at present, and have therefore been unwilling to play around with the inflation framework.
That, in fact, is why the chairman is so attracted to introducing a formal inflation target in the first place. And why this week’s developments on communications policy are likely to be a lot more cautious, and more conventional, than many New Keynesian economists would like to see.
