Building A Stronger Forward Guidance

WSJ reporter Ben Leubsdorf summarized a recent speech given by the president of Federal Reserve Bank of Boston, Eric Rosengren. The original text of speech can be found here. In his speech, President Eric Rosengren claimed that Forward Guidance should be more specific. Here is two different statements of Fed’s Forward Guidance.

During the Great Recession, FOMC had fairly specific guidance such as “that short-term rates would remain low until we had seen significant improvement in labor market- improvement that could be proxied by seeing the unemployment rate fall to the 6.5 percent threshold” (Rosengren, p3). On the other hand, in March of 2014, FOMC adjusted their Forward Guidance as U.S. economy picks up its pace and especially seeing unemployment rate dropping down to 6.7% form 7.5%. Witnessing optimistic incoming data, Fed responded this with by cutting their bond purchase. At the March FOMC meeting, Fed suggested that “ for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent-run goal, and provided that longer-term inflation expectations remain well anchored” (Rosengren, p3).

Rosengren admits that recent announcement of Forward Guidance is bit less specific given that it is missing specific targeted goal, such as 6.5% unemployment rate in the previous example. WSJ reported Ben Leubsdorf named his article, Rosengren: Fed’s Forward Guidance Should be Linked to Employment, Inflation Data, is somewhat missing the core message of what Rosengren had said in his speech. For example, Rosengren emphasizes that in order to achieve both sustainable employment and price level, “Forward Guidance should be increasingly focused on how quickly we expect to make progress on inflation “(Rosengren, p4). So it is not just about linking Forward Guidance to employment and inflation data.

In order to create a positive attention, Fed’s Forward Guidance should be specific but not overly specific to a level which Fed must be able to manage market’s uncertainties. For example, Rosengren suggests FOMC to “keep short-term interest rates at very low levels until the economy is within one year of reaching full employment and 2 percent inflation, based on the trends in incoming data and an assumption about how they will continue” (Rosengren, p5). By specifically hinting to market that Fed will follow the incoming data like summary of the economic projections (SEP) which has been routinely published by Federal Reserve Board members, Market watchers will become more prudent in analyzing the data which corresponds to the Fed’s Forward Guidance. I believe this will make the market more data oriented object rather than a rugby ball bouncing up and down with variety of unsorted uncertainties. In addition, benefit of having data orientated market that accords with Fed’s monetary policy can reduce the volatility of market risks compare to the absence of data oriented market. When Fed reduces the volatility of market sways, this will hugely benefit U.S. economy. One of the reasons, I think that Great Recession does not healed as quickly as Fed anticipated is that market’s own expectations were not necessary aligned with Fed’s expectations of market. For example, investors have their own expectations and have been playing their own expectation game.

In other words, there are too many boats searching for the same treasure, yet they bumped into each other and crashed, because they all have different beliefs even though the same map has been distributed to them. One possible reason that those boats are sailing their own ways and creating havoc during the course of the journey can be found in the lack of confidence of map that was given. In this analogy, map distributor is the Fed and sailors of boat are market participants.

Absence of complete information, how can we sail in a similar direction knowing that we may not find the treasure? Answer is: We have to make them believe. On way, I like to propose is by using the concept from the Ellsberg paradox. “The basic idea is that people overwhelmingly prefer taking on risk in situation where they know specific odds rather than an alternative risk scenario in which odds are completely ambiguous” What I am suggesting to Fed is that Fed should release more information that can help market participants to determine the risks of following Fed’s direction. Markets will cautiously analyze the data, and will likely choose known risks rather than the odds that are unknown. Here, I am not encouraging the manipulation of data, but recommending a strategy which perhaps can align market expectations with Fed’s expectations of economy. Thus, it stirs more boats to sail in the same direction.

One thought on “Building A Stronger Forward Guidance

  1. psseo

    Great post! Even though some of criticism, I think the Fed’s forward guidance contribute to stabilization of financial markets and recovery of the economy. I wonder how in the future this forward guidance change.

Comments are closed.