Revised: The End of Forward Guidance

In December 2012, The Federal Reserve declared “it would not raise interest rates until America’s unemployment rate dropped to at least 6.5%, so long as inflation remained below 2.5%.”  This declaration represents one of the Fed’s most unique policy tools for impacting economic conditions at the zero lower bound: forward guidance.

Forward guidance is merely a promise of future monetary policy in order to impact current economic activity.  Today, the Fed employs forward guidance by promising to keep interest rates low until a 6.5% unemployment rate is reached.  Doing so allows investors to understand when and how future interest rates will change, thereby reducing uncertainty and encouraging investment today.  This heightened level of investment increase economic output and accelerate economic recovery.

Forward guidance is not a new tool.  At the onset of the lost decade in the 1990’s, the Bank of Japan promised to keep interest rates at zero “until deflationary concerns subside.”  In the United States, just a few years after the NASDAQ crashed, the Fed cut interest rates to 1% in 2003 and pledged to keep rates at this level “for a considerable period.”  While forward guidance has certainly evolved since the Great Recession (from vague statements about time to concrete thresholds determining policy changes), the zero lower bound necessitates its use even today.  Because the Fed is unable to lower short-term interest rates to their necessary, negative value, it has no choice but to alter long-term rates in an effort to stimulate today’s economy.

While forward guidance seems to have been an effective (though painfully slow) policy tool in the last 6 years, recent debate has me worried about its legitimacy.  As the unemployment rate nears the 6.5% threshold targeted by the Federal Reserve, there is talk (and concern) about hikes in interest rates.  In my opinion, once a 6.5% unemployment rate is achieved, the Fed should raise interest rates per it’s promise.  However an intriguingly titled Wall Street Journal article caught my eye recently.  With the title “Grand Central: As Unemployment Falls, Fed Doves Pivot to Low Inflation Concern,” this article had me worried that the Fed will not keep its promise to raise interest rates once 6.5% unemployment is achieved.

The article notes that some Fed doves are concerned about low levels of inflation.  In 2012, the Fed targeted an annual inflation rate of 2%, but in reality has only generated average inflation of 1.3% (uncertainty about the effects of Quantitative Easing has resulted in more conservative stimulus).  As shown in the graph below, this discrepancy in rates has caused a large discrepancy between predicted and actual price levels.  Many doves support the continuation of low interest rates (even after unemployment reaches 6.5%) so as to boost short-term inflation above 2% and bring actual price levels in line with predicted price levels.

Screen shot 2014-03-24 at 12.00.01 PM

I have two concerns about continually low interest rates.  The first relates to the motivation for boosting inflation.  I certainly agree that inflation can be helpful in the face of the zero lower bound by allowing for negative real interest rates.  However, once the Fed reaches its 6.5% unemployment target, its has achieved its goals.  Accordingly there should be no further need for large economic stimulus.  At least, this would be the case if the Fed stayed committed to its December 2012 promise.

The issue of commitment brings me to my second and more important concern about continually low interest rates: failing to raise interest rates undermines forward guidance, thereby challenging the trustworthiness of the Fed and potentially eliminating a useful policy tool.  In my opinion, if the Fed does not alter the direction of interest rates after reaching a 6.5% unemployment rate (as many doves are suggesting), it is completely disregarding the forward guidance promises made in 2012.  Granted, while these promises were qualified by terms like “necessary” and “sufficient,” the Fed did commit to a policy change once unemployment reaches 6.5%.  If the Fed does not change its policy after reaching this threshold, my trust in the Fed will be destroyed.  If private investors (whose decisions depend of trusting the Fed’s promises) think like me, they will also lose trust in the Fed.  Should private investors lose trust in the Fed, forward guidance will be eliminated as a policy tool entirely, making economic stimulus at the zero lower bound extremely difficult.

Ultimately, forward guidance is a tricky tool as it locks the Fed into a single, long-term strategy.  Deviation from this strategy (which might occur very soon) undermines the Fed’s trustworthiness and eliminates forward guidance as a policy tool entirely.  In this way, effective forward guidance requires consensus as to the long-term strategy of central banks.  But today, this consensus simply does not exist, and there is frequent debate as to which metrics the Fed should target.  Some believe inflation should be the Fed’s key goal; others are more focused on unemployment and still others are focused on financial stability.  In my opinion, this type of debate will always exist.  And I think this debate should exist.  The Federal Reserve would be foolish to not reassess its long-term strategies given changes in the economic environment.  Like a successful business, an effective central bank should not commit to a single strategy, but rather should address each economic situation individually to respond optimally.

For this reason, I believe forward guidance, while powerful, is a foolish economic tool.  In order to preserve private investors’ trust, forward guidance locks the Fed into a single long-term strategy, inhibiting its ability to respond to unanticipated changes in economic conditions.  Unfortunately, given the zero lower bound, forward guidance has become necessary (as short term interest rates of 0% do not provide sufficient stimulus).  Therefore, in order to eliminate forward guidance as a policy tool, I believe addressing the zero lower bound should be a key priority of central banks.  So long as the zero lower bound exists and forward guidance remains necessary, the Fed cannot do its job as well as possible.