We all know that the Fed has been conducting an “unconventional” monetary policy since the end of the recession. The policy consists of bond-buying program and forward guidance program. A familiar role that Fed’s forward guidance play is to insure investors and market that the Fed will be pursuing low interest rate policy during the period of time described in the guidance statement.
In this post I want to emphasize another role the forward guidance program take in the successful stable economic recovery. By being as transparent as possible about its ongoing monetary policy and future policy, through the forward guidance tool, the Fed officials try to give as much information as possible to market on the future moves in the monetary policy. Why the Fed has been doing this?
The answer relates to rational expectations. According to rational expectation model, economic outcome will depend on what agents, such as investors, firms, and consumers, expect to happen. By providing statements on the future unfolding of monetary policy, the Fed changes and strengthens market’s expectation about the monetary policy. Market then includes their expectations of monetary policy, which are partially created by the forward guidance, in their decision making. When the actual time of policy change comes, the market will react to it little or not at all depending on how their expectation was true. That means, a policy change, in this case, increasing federal funds rate, will receive a little reaction from the market at the time of the event since the market will have foreseen the coming of the policy change. In other words, the market will be considerably stable at the moment of the announcement.
Now, if the Fed hasn’t been pursuing the forward guidance policy for these years, there would have been a much greater monetary policy guessing game before every Fed meeting and more expectations would have been wrong in the absence of the forward guidance. As rational expectation theory would say, the agents whose expectations weren’t met by the policy change would have to make a change in their economic decision after the time of the event. That means there would have been greater stability in the financial market since the Fed’s raise of the interest rate started looking imminent.
In conclusion, the Fed has been stabilizing the markets since the end of the recession partially through its forward guidance program to give clear direction on the market’s expectation of monetary policy. Janet Yellen’s speeches following the Fed’s meeting in March have been to clarify the uncertainty created by the Fed’s meeting regarding the timing of the interest rate rise. That is what Yellen should be doing to ensure that market will not be surprised by the Fed’s move sometime in 2015 and react to it creating instability in the markets.