Factors That Affect Effectiveness of Forward Guidance

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?

Thought on Forward Guidance: Proposal for the Fed

The FED has been pursuing its so called "forward guidance" program hoping it could stimulate economy by convincing the persistence of low interest rate policy. It stated that it sees the current low interest rate appropriate as long as the unemployment rate remains above 6.5% and the expected inflation in one to two years is below 2.5%. According to the statement, it will consider the broader labor indicators and inflation expectations to decide how long it will continue the near zero interest rate policy once the unemployment rate drops to 6.5%. Therefore, it is very up in the air when the FED is increasing the federal funds rate.

We know that the latest report shows the unemployment rate is 6.6%.  This rate indicates that even though the monthly net number of jobs added hasn't been up to the projections for last two months, the FED will soon be deciding its future policy and writing up its well-into-future forward guidance once the unemployment rate hits 6.5%.

After all, the FED's low interest rate policy has been directed toward increasing investment. But there could be different type of "forward guidance" that could potentially create more investment as the FED wishes. My proposal to the FED is that:

a) It should forward guide the market by putting hard deadline on when it is increasing the federal funds rate and therefore the market interest rates. How this clear deadline for increase in federal funds rate works is following: If the FED successfully (!) convince the market that it will indeed push up the federal funds rate, the investors will have clear expectation of when the overall market interest rates are rising. Therefore, realizing the higher investment cost in the specific future, firms will have incentive to borrow and invest today before the FED raises the interest rate. Hence, the investment could increase as the FED has been wishing. This argument is analogical to the people's consumption when there is very high inflation expectation. If the expected inflation is very high, people would try to buy goods as soon as possible. But the one difference between these two analogies is we don't know what interest rate is very high to be analogy to the high inflation rate.

One might say that then if there is higher demand for loanable funds because of this policy, the interest rate will rise in the loanable funds market. But we have to remember, the FED has control over overall interest rate in the economy (or I believe so), it will pursue its current near zero interest rate policy until the date it forward guided comes.

b) Again, to succeed in increasing investment, the FED must be able convince the market that it is indeed increasing the federal funds rate at that certain date, To convince the market, the FED should set the date to be in near future and interest rate minimally higher in first few periods and commit to what it said.

According to latest report, the expectation of the FED's federal funds rate in June 2015 has lowered in a recent month. This might be showing that the FED's forward guidance indeed successfully convinced the market that the FED will be pursuing near zero interest rate policy. If current forward guidance is indeed somewhat successful, I believe the proposed forward guidance could be also successful.

Remember, at the time when the FED sets the specific date to increase the interest rate, the interest rate will be still zero percent, therefore there will be no negative shock to the total investment.

The problem to implement this forward guidance is that the FED cannot surely know how bad or good the economy will be performing at the time of its forward guided date. The FED could announce its first date to increase the interest rate once the unemployment rate reaches 6.5%. If the FED chooses 3 months to increase the federal funds rate after the unemployment reaches 6.5%, it can study how the investment behaved during this 3 months when the market believes the increase in the interest rate is coming. If the sign turns out to be good, the FED can further implement this "hard deadline for minimal increase in federal funds rate" forward guidance.

Reverse Repurchase Program and Its Use in American "Abenomics"

We all have been aware of the FED's latest decision to taper its bond-buying program by $10 billion from the Federal Open Market Committee (FOMC) meeting this week. Another interesting decision that came out, at least to me, was the decision to extend its reverse repurchase program (also known as reverse repo) by a year. By implementing reverse repurchase program, the FED aims to be able to control the short-term interest rate when it needs to raise it in the future. The advantage of this program is that the FED doesn't have to pull money out of the economy to raise the interest rate when it wants. This advantage of not having to lower the money supply in the future explains how this program can be implemented to achieve a shift in the FED's monetary policy. This shift is to follow permanent increase in the monetary base, which is what the Bank of Japan has been doing under Abenomics.

In the US, QE1 and QE2 and Japan's first QE during 2001-2006 were seen by the public as a temporary increase in the money supply by the central banks rather than permanent one. On the other hand, QE policy the BOJ has been employing since April 2013 is to double the money supply permanently. David Beckworth explained how the way public sees an easy monetary policy as temporary vs permanent money supply increase affects the performance of these QE programs. In his words:

"I have long argued, along with other Market Monetarists, that the Fed could solve this problem by adopting a NGDP leveltarget. Why would this help? The key reason is that it would create an expectation that some portion of the monetary base growth from the asset purchases would be permanent (and non-sterilized by IOER). That, in turn, would mean a permanently higher price level and nominal income in the future. Such knowledge would cause current investors to rebalance their portfolios away from highly liquid, low-yielding assets towards less liquid, higher yielding assets. The portfolio rebalancing, in turn, would raise asset prices, lower risk premiums, increase financial intermediation, spur more investment spending, and ultimately catalyze a robust recovery in aggregate demand."

In short, when people sees expansionary monetary policy as permanent one rather temporary, they will increase their spending today. For QE3, Beckworth explains that it has had some indication of permanent money supply growth with "its data-dependent nature and appears to have offset much of the 2013 fiscal drag" and this could be a reason

Now let's get back to the reverse repo program. By using this tool instead of targeting federal funds rate, it can convince the public that it will not lower the money base in the future to raise the interest rate. In other words, the FED will be able to make shift to a monetary policy that will sustain the higher monetary base created by QE3 permanently AND convince the public that it will be indeed permanent. This type of monetary policy or QE that raises the monetary base permanently rather than temporarily could achieve more private spending and economic growth as we can see from Japan's latest growth under Abenomics (one could argue that the other two main policies or arrows of the Abenomics also helped Japanese economy to improve). Of course, we cannot take the latest Japan's inflationary success and economic growth in 2013 as a product of the Abenomics. And the U.S. is far from implementing this kind of economic reform consisting of fiscal, monetary, and regulatory policies, but if the Abenomics turns out to be Japan's success story in the future, the U.S. should study this "real life experiment" of Japan. If it chooses to do the experiment on itself, the reverse repo program is their experiment tool.

The Fed's New Tool for Increasing the Short Term Interest Rate

As the U.S. economy starts to look better, the Fed eventually has to increase its federal funds rate. The Fed has stated that it is planning to keep the near zero federal funds rate until the unemployment reaches 6.5 % as long as the inflation rate and expected inflation remains low.

Now, the question is whether the Fed will be able to increase the short term rate in the economy as it desires when the correct time comes through changing its federal funds target rate. As the Fed has been conducting QEs since the recession ended, its balance sheet  reached  $4 trillion mark in last December and bank reserves at the Fed increased greatly.

Source: http://www.piie.com/publications/pb/pb14-4.pdf

To increase the short term interest rate in the future, under current system, the Fed has to sell government bonds to pull money out of the economy, therefore increases the interest rate. But since it has put in enormous amount of reserves for last few years, the Fed faces a problem of selling huge amount of asset to effectively increase the interest rate.

Since September 2013, the Fed has been experimenting a new tool to control the short term interest rate. This new tool called a reverse repurchase program works this way: the Fed sells its asset in the System Open Market Account to money-market mutual funds, banks, securities dealers, government-sponsored enterprises and others with a condition that it will buy back those assets in the future for higher price than it sold to them. In other words, the Fed, under this program, borrows from those institutions with collateral of Treasury Securities. The difference between the sale price and repurchase price along with a length of time between these indicate the interest rate the Fed pays.

When the Fed wants to increase short term rates, it can increase the reverse repurchase interest rate. When the financial institutions see this higher interest rate paid buy the Fed, they aren't willing to borrow reserves each other below this rate because they can make more buy purchasing assets from the Fed and selling back. Therefore, it can effectively put a floor for the short term interest rates that banks charge each other. Moreover, through raising this rate, the Fed can affect the overall short term interest rate in the economy. Also, using reverse repurchase program, the Fed doesn't have to shrink its balance sheet; therefore, it can use its assets when it faces a problem.

One counterproductive effect this program could have is that when the Fed shifts to this policy, the Fed will be expanding the monetary base through its payment to financial institutions. That is reverse of what the Fed tries to do when it needs to raise the interest rate in the economy.

Along with targeting reverse repurchase interest rate, the Fed has to increase the interest on reserves, which is currently 0.25%, when it raises the short term interest rate to prevent depository banks from lending too much credit and causing inflation.

This policy has been examined by the Fed since September, and there has been a research paper on its effectiveness. Whether the Fed will employ this policy in the future is interesting thing to put eye on.

Related article on the Wall Street Journal:

Former Fed Economist Call For Central Bank to Scrap Fed Funds Rate Target

Fed Moves Toward New Tool for Setting Rates