The limits of Federal Reserve forward guidance on interest rates
The ‘taper tantrum’ of May and June, as the mid-year spike in interest rates became known, appears to have humbled Federal Reserve officials into having a second look at their convictions about the power of forward guidance on interest rate policy.
Take James Bullard, president of the St. Louis Fed. He acknowledged on Friday that the Fed’s view of the separation between rates guidance and asset purchases had not been fully accepted by financial markets. “This presents challenges for the Committee,” he noted.
A decision to modestly reduce the pace of asset purchases can still leave a very accommodative policy in place to the extent forward guidance remains intact.
The Committee needs to either convince markets that the two tools are separate, or learn to live with the joint effects of tapering on both the pace of asset purchases and the perception of future policy rates.
San Francisco Fed President John Williams also recently outlined some of the drawbacks on relying too greatly on promises of future behavior.
While forward guidance brings with it a number of benefits, it is also necessary to acknowledge both its limitations and some potential drawbacks. First, efficacy depends on credibility. In severe downturns, the likes of which we have recently experienced, appropriate forward guidance can stretch years into the future.
Public credulity may be tested by statements relating to events so far off, particularly when policy makers may be different than the ones making assertions today. Second, clearly communicating monetary policy and the associated data dependence is difficult to do well. Asset-price fluctuations over the past several months, sparked by Fed communications, demonstrate how hard it is to effectively convey FOMC policy plans in an evolving economic environment.
Just as good communication can reduce confusion and enhance the effectiveness of monetary policy, poor communication can do the opposite. Third, there is a danger of creating an over-reliance on Fed communication. While we want to convey our expectations and intentions, we want to avoid the public substituting independent thought with an attempt to read the Fed tea leaves.
Those issues notwithstanding, I expect that forward guidance will continue to play a central role in Federal Reserve policy in coming years.