The "forwards guidance" has been he FED's one of the novel tools to boost the economy after the recession at the zero lower bound. Forward guidance is the FED's public statement on how it will change or unchange the federal funds rate. We can see the latest forward guidance statement from the FED's January statement:
Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. The Committee 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 no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.
Essentially, what the FED tries to achieve by such statements is to guide the market expectation of the interest rate. The FED has been using forward guidance to lower the market expectation of interest rate during the period it stated.
I should explain two types of forward guidance as introduced by Campbell et al. (2012). Odyssean type of forward guidance is when the FED commits to low interest rate policy even after the economic condition raises the natural interest rate above zero, and Delphic forward guidance is when the FED publicly forecasts its monetary policy's shape regarding the future shocks in the economy. We can see that the FED has been pursuing the Odyssean forward guidance since September 2012 because it publicly stated then that the the low interest rate policy would stay even after the economy strengthens:
To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.
Having talked the basics of the forward guidance, we should study further what factors play a role in effective forward guidance program. First, the FED's credibility decides whether the forward guidance will achieve its goal of lowering the market expectation of interest rate.If the market doesn't believe in the FED's plan for the future interest rate, the forward guidance cannot stimulate the economy as the FED hopes. After all, what the forward guidance's mechanism bases on is the FED's policymakers' hope that the market will take the FED's statement on the future of the monetary policy as granted. Reports are coming in saying that the FED has lost its credibility since the FED is no way raising the federal funds rate even though the unemployment rate is very likely to reach 6.5% very soon. I can understand why this might distort the FED's credibility. If we look at the FED's October meeting's press statement, following statement follows the same statement in the January statement above. October's statement reads:
...In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.
But in December, the FED added one more statement following the above statement. The added statement follows:
...The Committee now anticipates, 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 below the Committee's 2 percent longer-run goal.
From this change in the forward guidance, one can say that the FED didn't follow what it forward guided previously. But to me, I don't see any credibility problem for the FED. Didn't the FED literally say in the above statement that it will more likely to extend the low interest rate even past the time unemployment rate drops below 6.5%? Didn't the FED have to modify its stand on its future interest rate policy according to the economics condition? Therefore, seeing the FED as not committing to its forward guided policy is like saying the FED has one chance to state what the interest rate will be in the next few years, and if it doesn't follow that, we cannot believe in the FED.
Rather, I think the FED faces credibility problem when it suddenly increases the interest rate when the unemployment rate lowers to 6.5% because current forward guidance tells us that the FED will very likely be pursuing near zero interest rate even after the unemployment rate hits the threshold.
Second factor that determines the effectiveness of the forward guidance is the public's forecast of the recovery. If the public believes that the economy will soon recover, then the public naturally expects a higher interest rate in the future. In that case, when the FED successfully forward guides its low interest rate policy, the consumption and investment will increase because the FED has just lowered the public's interest rate expectation. Hence, the firms and households are more likely to consume and invest more. On the other hand, if the public expects the economy to be still recovering from the recession in the future, it expects the interest rate to be lower as it is now. In that case, even the FED forward guides the economy by promising the persistence of low interest rate, the public's decision on consumption and investment isn't affected that much since its interest rate expectation isn't changed.
The working paper by Gavin et al.(December 2013) concludes following:
The stronger the expected recovery, the more households believe the future nominal interest rate will rise and the larger the stimulative effect of forward guidance on current consumption. We find that news of a −50 basis point shock to the nominal interest rate next period leads to an increase in current consumption of about 0.20 percent.
In summing up the discussion, I believe the FED's current forward guidance policy's stimulative effect is still ambiguous considering the FED's mixed signals on the economic outlook through its bond buying program tapering, which gives the market positive sign, and its reluctance to increase the interest rate even though the unemployment rate is almost at the threshold, which might worry the market. Interesting news to follow in next few months will be the FED's next change in its forward guidance program.
PS. Should the FED and Mrs. Yellen not-forward guide the public as the Chicago Bulls and Derrick Rose do?
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