Tag Archives: federal reserve

(Revised) Fed, Raise the Inflation Target

Originally posted on March 29th

Friday’s report of the personal consumption expenditure price index, which the Fed prefers, shows that year-to-year price index grew by 0.9% in February. This means that the inflation rate has been below the Fed’s target of 2 percent inflation rate for 21 consecutive months.

While this low inflation rate has been allowing the Fed to pursue its quantitative easing program and low interest rate policy , the Fed policy makers also know that higher inflation rate around their target of 2 percent would make their job easier, simply lowering the real interest rate. But it seems like the Fed has been short of achieving its “target” for 21 months. A question we should ask from ourselves is that: is the Fed unable to hit its target? or is the Fed actually targeting lower than their so-called “target”? In my Monday’s post, I made a case for the second question getting an answer “yes!”. If the Fed is indeed targeting inflation rate lower than its 2 percent “target”, the points following are useless since the Fed policymakers want low inflation anyways.

Now if we are in the world where the Fed has actually been unable to hit its inflation “target” given that it wants to hit it so badly, my policy prescription for the Fed is to increase its inflation target from 2 percent to 3 percent or somewhere around that for the duration of the recovery. Note that, I am not suggesting to raise inflation target to 4 percent or other for the long-run as Laurence Ball and Olivier Blanchard suggested, but to raise it until the economy recovers.

The Fed could target this higher inflation rate by declaring in its meeting statements that the Fed will be comfortable with inflation rate considerably higher than 2 percent when deciding when to raise the fed funds rate. Let’s look at the Fed’s latest statement:

“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.”

The Fed, in my policy prescription, should change “run below the Committee’s 2 percent longer-run goal” to “run below 3 percent” (or some rate around that). That change should have positive effect on inflation expectation. If the Fed believes the inflation expectation hasn’t been responsive to its inflation rate target, that is great for the Fed since it could further state higher inflation target such as 4 percent to raise the expectation more while not actually raising the inflation higher.

But again, raising inflation target makes sense to me if the Fed does want to raise the inflation expectation. But considering its tapering QE even though their desired 2 percent inflation isn’t seen to be reached for some time, I am puzzled by what inflation rate the Fed wants. Or are the Fed policymakers actually buying Stephen Williamson’s paper?

Citigroup in the Hot Seat

Earlier this week, I wrote a post about’s the Fed’s stress test. 29 out of 30 banks passed the test, but the bank that fell below the Fed’s standards was Citigroup. To re-summarize what the stress test actually is- the Fed takes each particular bank’s balance sheet and puts it through a rigorous simulation involving high inflation and severe unemployment. The first portion of the test involves quantitative measures such as leverage ratios, capital levels, and other quantitative measures that test whether the bank can withstand an economic shock. From here, the Fed checks the bank’s capital levels over time. Each bank later proves itself to the Fed through a qualitative test, which measures how the bank would pay dividends and manage capital given that the economy is operating in a recession.

Since the Fed gave its decision on Wednesday, shareholders are not happy because Citi will not be receiving the Fed’s permission to increase dividends and share buybacks. Shareholders reacted by selling Citigroup stock, which is now down about 4%, falling $2.71 to $47.45. Mentioned in WSJ, one portfolio manager at a hedge fund “said he liquidated his Citi holdings after the failed stress test. The investor said he was frustrated because he had had discussions over the past six months with Chief Financial Officer John Gerspach and members of the bank’s investor-relations team, and had been reassured that the bank’s relationship with regulators ‘was improving every single day,’ the investor recalled”.

However, it seems that Citigroup’s capital levels aren’t the actual problem. Their capital levels were actually above the Fed’s minimum threshold of 5% (during the simulated economic recession)- at 6.5% to be exact. The concern was that Citigroup failed the second portion of the test, in which the bank failed to sufficiently prove to the Fed how it would successfully manage capital through a recession. Another reason why the 2014 test was such a big concern was because Citigroup failed to pass the 2012 stress test as well. Even though Citigroup passed the 2013 test, the Fed notified the bank that they needed to refine their risk models and loss estimates. Apparently, Citigroup underestimated its projected losses by about $15 billion in 2013.

Since the 2008 financial crisis, the second portion (qualitative portion) has became much more important. It measures how the bank would actually manage a recession, incorporates past lessons and concerns, takes into account how a bank handles its technology, and also tests how it would handle costly litigation. In my opinion, I think the Fed stepping up their game is a great thing. Even though banks may not like the tightening in regulation, it sends the message that banks need to step up their game as well. For the most part, the Fed is seeing good results. This is evident through 29 out of 30 banks passing the test and according to the WSJ article, banks have more than doubled capital levels since 2009. I think that the market’s perception is what’s most important. Even though Citigroup has ample capital, it needs to convey to its share holders that it can manage this capital throughout a recession. Although the first portion of the stress test is important, the second qualitative portion is what’s practical and relevant for shareholders.

Sorry Krugman, It Is Not Happening (or seems to be)

In his blog post on last Friday, Paul Krugman argues that the Fed should be targeting 4 percent inflation rate, which is, according to him, the inflation rate that is needed when the economy is at the zero lower bound, instead of current inflation target of 2 percent. He argues that by targeting inflation rate which is lower than a rate needed by the economy to get boost, the Fed does nothing to raise the inflation rate, which is currently below 2 percent, because even if the market believes in the Fed’s target of 2 percent inflation rate at the beginning, its inflation expectation will decrease as time goes and actual inflation will be back at the low level. But, according to him, if the Fed explicitly targets 4 percent inflation rate, assuming 4 percent inflation is the right amount to boost the economy, this will give boost to the economy and hence drives the inflation up. However, the Fed is not even considering to target above 2 percent inflation rate as opposed to Krugman’s inflation target of somewhere around 4 percent. We can see an evidence for the Fed being hawkish.

In the Fed’s recent statement, it dropped infamous 6.5 percent unemployment threshold for raising short-term interest rate. Known as the Evans rule, the Fed’s former quantitative forward guidance statement was giving timeline for raising interest rate closely tied to the unemployment rate. As we know, once the unemployment rate unexpectedly (for the Fed) dropped to 6.6 percent in last month, it had to change its forward guidance program because if it had continued mentioning 6.5 percent threshold, and once the unemployment rate had reached the threshold, the Fed could have then made market expectation of increasing short-term interest rate when the economy needed the opposite. To avoid this unexpected mistake, they dropped the quantitative threshold for raising the interest rate.

The Fed undoubtedly has learned its lesson: Never underestimate the economy or should I say power of some number like 6.5? Having experienced the problem of changing the forward guidance appropriately, the Fed must have now issued their statement with great care of not choosing any random numerical threshold. But guess what? The Fed’s statement still includes the inflation target of 2 percent. The Fed’s latest statement reads:

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.

Let’s now imagine that somehow the inflation rate reaches around 1.9 percent in one of the coming months and assume the economy will not have gotten out of the recession slack (which is very likely), the Fed now faces the same problem it faced two months ago when the unemployment rate almost hit 6.5 percent threshold, but, in this case, only the inflation rate almost hits the target of 2 percent. Should then the Fed increase the federal funds rate according to its statement inferred if the inflation rate reaches 2 percent target? or should the Fed change its forward guidance again and drop the inflation rate target as it did unemployment rate threshold? Interestingly, the Fed will do neither of them because:

First, they learned its lesson of changing the guidance prematurely. Second, and more importantly, they KNOW that they will never face the inflation rate close to 2 percent during the recovery; hence, they won’t have to do either of above.

In other words, from the Fed’s current statement and its current mistake, we can almost be sure that it will never target the inflation rate above 2 percent as long as the economy is still recovering. Two percent inflation target is then an upper bound for the inflation rate the Fed targets.

Some people has argued even that the upper limit of 2 percent for the inflation target is indeed what the Fed has been pursuing for these years.

Therefore, it seems unlikely that Krugman will see whether 4 percent inflation target could get the economy back to work. Sorry Krugman, it is not happening (or seems to be).





Fed’s Stress Test

Things are looking up for big banks. The Federal Reserve’s annual “stress test” of big banks’ financial health showed that the largest US firms are strong enough to survive a severe economic downfall. 29 of 30 of the largest institutions have ample capital to continue lending through a hypothetical economic downfall lasting to 2015- a downfall being defined as a severe drop in housing prices and unemployment.

The Fed’s annual “stress test” is designed to ensure that large banks can survive big losses during economic downtimes. These stress test results will be critical for the Fed’s decision next week to approve or deny each banks’ plans for giving billions of dollars back to shareholders through dividends or share buybacks. However, performing well on this stress test is not an outright guarantee of a bank’s survival because the Fed also considers more subjective measures such as the strength of a bank’s internal risk management.

The Fed’s recessionary stress test scenario used was a rising unemployment rate, a steep drop in housing prices, and a 50% decline in stock prices over nine quarters. The baseline that they used to measure whether each bank would survive is a minimum tier 1 common capital ratio of 5%. The Tier 1 common capital ratio is a measure of a bank’s financial strength in that it measures a bank’s core equity capital compared with its total risk-weighted assets. If the bank is over the 5% threshold, it should be able to increase dividends or buy back stock. The graph below shows the banks that could have survived the test in 2013 versus the banks that could have survived now in 2014. Surprisingly, many of the larger well-known banks ranked near the bottom of the pack. “The six biggest banks earned $76 billion in 2013, just $6 billion shy of their collective all-time high. All U.S. banks earned a record $154.6 billion, according to data compiled by SNL Financial. Some of the biggest financial institutions, including Bank of America Corp. BAC -2.01% and Morgan Stanley, MS -0.58% haven’t boosted dividend payouts since the financial crisis.”

Screen Shot 2014-03-23 at 9.56.18 PM

In my opinion, I believe these results are good for investors because banks will be able to reward them by raising dividends and buying back shares in the near future. In the scenario where there would be a 2015 economic downfall- even though the current housing market looks somewhat stable, it’s also good news to know that we have a bit of a security blanket if the unemployment rate were to keep ticking up.

FED renews focus on its duel mandate

Wednesday, the FED dropped the unemployment rate as a benchmark for when to raise the federal funds rate.  It has hinted at doing this for since January, since the indicator has been decreasing due to discouraged workers dropping out of the workforce as opposed to being hired.  In its place, the FED has said it will use a more comprehensive approach, as it seeks to continue its accommodating monetary policy until inflation becomes a problem or employment picks up.

Not everyone shares this opinion, not even on the Board of Governors.  The president of the Minneapolis Federal Reserve Bank, Narayana Kocherlakota, was the lone dissenter in this past weeks FOMC meeting.  While he argues the new policy will lead to uncertainty, I question the viability of his alternative.

Central to his disagreement is the ambiguous nature of the FED’s guidance with respect to he interest rate going forward. Mr. Kocherlakota thinks that without a firm number to track, the FED’s commitment to its message won’t be taken seriously.  However, the FED has had to move its previous number (6.5% unemployment rate) because it was about to be realized, and the FED would like to see the economy closer to full employment before rates increase.  If the conviction of the FED rested on a deterministic number, then picking another on may seem as arbitrary as the first.

As an alternative, he suggests lowering the unemployment number to 5.5%, to provide a more determined target.  I feel that there is a problem with this.  Using data series from FRED, one of which is graphed below, it can be seen that the natural rate of unemployment in the short and long term is at or above 5.5% for the foreseeable future.  Using it as a guide provides no valuable information since one would think that the FED would try to step off the zero lower bound if the United States was at the natural rate of employment.  The FED needs a different metric in order to give it the leeway it needs.


If a policy with a firm benchmark is desired to insure credibility and confidence, instead of the unemployment rate why not use inflation as a guide?  While some have argued to raise the target inflation, there are very rational reasons for why 2% was chosen, and nothing so extreme is needed.  Instead, the FED should say that the central bank will do what it feels is prudent to foster a return to the natural level of output while inflation remains below the targeted levels.

I feel that Inflation will play a central role in the FED’s decision to raise interest rates, whether it wants to put a number to it or not.  With inflation at its current levels, the FED has the price stability it needs.  Provided this price stability remains, the FED should do all it can to stimulate employment.  While a firm number would bestow confidence in markets, it can also cause exactly what we are seeing now when the economy reaches predetermined levels in unanticipated ways.  Based on past results, the United States should have a little more confidence in its Central Bank to handle its business.

Making Sense of the Fed’s UE Target Drop

Lately, there have been uneven wage gains in the economy, which we have seen has had recent implications at the Fed. In some segments of the economy, wages have been booming. In others, many people have been left behind and have still suffered lower incomes now five years after the recession has ended. For example, there has been a surge in home building, which has driven up demand for skilled labor. Also, the trucking industry has a large proportion of baby boomers. Hence, they are expecting a larger amount of drivers to retire in the coming years so unequal wage gains will go to more experienced truck drivers.

Workers in blue-collar, largely skilled fields have been the lucky ones. They are able to receive top pay because of shortages of qualified workers and some blue-collar workers also have a willingness to take demanding jobs in remote areas. However, chances of the recovery actually picking up will occur when workers across more industries are able to secure wage gains. Stagnant incomes of Americans create a vicious cycle that leaves businesses waiting for stronger spending before they are able to increase hiring and investment. Just as we learned in class, higher spending is the way out of a recession.

At the Fed, officials have been monitoring wage measures to predict the health of the economy in order to make sound decisions regarding interest-rate policy. At Wednesday’s central bank policy meeting, Janet Yellen commented that wages are currently “signaling weakness in the labor market”. However, a debate emerged within the Fed regarding labor-market slack and upward wage pressures. This is evident through the fact that they recently dropped their unemployment rate target in order to account for other labor market measures. Ms. Yellen also commented that although one gauge of wage growth “suggests some uptick, most measures of wage increase are running at very low levels”. We can see the implications of these sluggish measures of wage increase through worker shortages in specific regions and occupations.

In my opinion, I think it was a good idea that the Fed dropped the unemployment rate target and I believe that it was done because it was an inaccurate measure of the current economy. In my last post, I commented on the other specific measures of the job market that the Fed is currently using. Many of the jobless people in the 6.7% figure are long-term unemployed who are unlikely to find jobs. Also, the 6.7% misses the Americans who want full-time work but are stuck in part-time work or gave up looking. With such contrasting measures included in the same percentage rate, it was a sound decision that the Fed look more carefully to other measures.

Fed Drops Unemployment Target

In recent news, the Fed is still staying on course with the bond buying program. However, some changes have been made to expand the array of indicators used to start raising short-term interest rates, rather than solely focusing on the unemployment rate. Also, Yellen reported at the meeting that the Fed will keep short-term rates lower than usual even after the unemployment and inflation rates return to long-term levels.

In regard to the unemployment rate, the Fed has now decided to drop the connection that it once made to raising the interest rate once the economy has reached the 6.5% unemployment threshold. The Fed plans to use other measures that it believes will represent the situation more accurately, such as the U6 measure (includes marginally attached workers and those working part time but prefer full time work), the share of workers who have been unemployed for six months or more, the rate at which people are quitting jobs, and the share of adults who are holding or seeking jobs.

In terms of interest rates, the Fed plans to keep the short-term rate lower than usual even after the jobless rate and inflation rate return to long term levels. Since the Fed expects a 4% rate as the normal long-run rate, this implies that officials do not expect rates to get back to this level anytime soon. Later actions taken by the Fed were to continue in reduce its bond-buying program to $55 billion. The long-term goal of the program is to hold down long-term interest rates, thus boosting spending, hiring, and growth.

One discrepancy that I noticed in the report was that even though the Fed said it plans to keep rates low well after the Fed returns to the long-run trend, the projections of the actual officials seemed a bit aggressive. More specifically, “Ten of 16 officials saw short-term rates rising to 1% or more by the end of 2015, with four of them right at 1%. Six officials saw rates below 1% by the end of 2015. In December, ten officials saw rates below 1% by the end of 2015. Twelve of 16 officials saw the target fed funds rate rising to 2% or above by the end of 2016, while four officials saw rates staying below 2% by the end of 2016.” In my opinion, I found the projections of these officials in comparison with Yellen’s earlier statements to be contradicting. From Yellen’s report, it seems that the Fed thinks the economy isn’t good enough right now, but will accelerate in the next 12 months- therefore warranting higher interest rates… but the Fed said that it plans to keep rates low “for a considerable time” after the bond buying program ends, given that the program is scheduled to end this fall. However, I anticipate this vagueness has to do with the fact that it depends on the condition of the labor market later this fall. If there were still high unemployment in the labor market and the inflation rate were still running below 2%, this would be good reason to believe that the Fed would hold the interest rate near current levels.

Fed Meeting: Staying the Course Spooks Markets

During the meeting of the Federal Reserve today, there were no surprises. According to the Wall Street Journal, “The Fed took several actions at the meeting. First, it pulled back to $55 billion from $65 billion its monthly bond-buying program, which is aimed at holding down long-term interest rates in hopes of boosting spending, hiring and growth. It was the third reduction in the bond purchases since December”. Asset purchases, which have been reduced from $85 billion a month, are on pace to be finished this coming October. Tapering and the ending (in the growth of) asset purchases was already priced into the market before the Fed’s meeting. In short, tapering is old news. Although asset purchases will likely be done in October, it remains to be seen how the Fed unwinds its massive balance sheet.

The Fed made some (relatively) more exciting changes with respect to forward guidance. According to the Wall Street Journal, “The central bank also rewrote its guidance about the likely path of short-term interest rates, putting less weight on the unemployment rate as a signpost for when rate increases will start”. As the unemployment rate has decreased to 6.7%, the 6.5% threshold for unemployment has become a less significant data point for policy makers. Furthermore, limitations of the unemployment rate have made it less meaningful as an indication of conditions in the labor market. I have mentioned in previous blogs that changes in the unemployment rate were not accurately portraying underlying conditions in labor markets . For example, an increase in the labor-force participation rate pushed the unemployment rate up to 6.7% in the last employment report. Although an increase in the labor-force participation rate is perceived as good, an increase in the unemployment rate is seen as bad. According to the Wall Street Journal, “It said instead [of the 6.5% unemployment threshold] that the Fed would look at a broad range of economic indicators in deciding when to start raising short-term rates from near zero, where they have been since December 2008“. Therefore, I believe it was a good decision to ditch the unemployment threshold in favor of a larger set of economic indicators.

In addition, the Fed reconfirmed its forward guidance on interest rates. According to the Wall Street Journal, “The Fed took several steps to assure investors that interest rates won’t rise soon and that when rates do start rising the increases will be gradual and limited. For example, the Fed’s official policy statement included a new line noting that officials expect to keep rates lower than normal even after inflation and employment return to their longer-run trends“. Although this policy has been understood for some time, the Fed has finally decided to state this unambiguously. As the Fed continues to taper, most people assume that rate hikes will follow – the question is how soon they will follow. In addition to other factors, the inflation rate is going to be important in determining when interest rates will rise. If inflation remains below target, then rates will remain low long after the bond buying ends.

However, financial markets fell today – possibly due to what was said during the Fed’s meeting. According to the Wall Street Journal, “Even though the Fed’s official policy statement sought to give assurances of continued low rates far into the future and Ms. Yellen played down rate-increase expectations, stock prices fell and longer-term rates on Treasury bonds moved up”. Despite the lack of surprises, the Fed’s meeting managed to somehow cause worry among investors.

Apparently, the source of concern was regarding the perception of imminent rate hikes. According to the Wall Street Journal, “In a press conference after the meeting, Ms. Yellen suggested that interest-rate increases might come about six months after the bond-buying program ends – a conclusion that could come this fall”. Financial markets were not anticipating interest rates to increase in early 2015. After many years of aggressive expansionary monetary policy, the financial markets have become very sensitive to interest rate decisions.

Today’s Fed meeting essentially affirmed that interest rates will begin rising in 2015. Considering that asset purchases will likely end in October 2014, interest rate hikes in 2015 might seem sudden to financial markets. Regardless, I believe interest rates will begin rising in 2015 so financial markets might as well begin pricing that in. According to the Wall Street Journal, “Ten of 16 officials saw short-term rates rising to 1% or more by the end of 2015, with four of them right at 1%. Six officials saw rates below 1% by the end of 2015“. Although Ms. Yellen might have misspoke during the press conference, I think it is good that she was very clear about when interest rates will begin rising. Assuming there are no setbacks, I believe the economy is strengthening to the point where interest rates can begin to rise.

February Employment Report: Implications for Monetary Policy

During her inaugural public appearance since becoming chairwoman, Janet Yellen confirmed that her intention is to continue the policies of her predecessor Ben Bernanke. As the economy improves, Yellen intends to slowly wind down the large-scale asset purchases – also referred to as quantitative easing (QE). I believe the February employment report provides data to confirm this plan, however, constructing forward guidance will still be a challenge.

The February employment report was released on Friday, March 7th and showed positive signs about the economic recovery. According to the Wall Street Journal, “Nonfarm payrolls grew by a seasonally adjusted 175,000 in February, the Labor Department said Friday, following a two month stretch of weaker growth. The unemployment rate ticked up to 6.7%, in part because more people joined the workforce”. Although the unemployment rate increased, it increased for all the right reasons. In this case, the rise in the unemployment rate reflects a rise in the labor force participation rate – a sign that conditions are improving in the labor market. As sentiment about the labor market improves, people are choosing to return to the labor force and pursue jobs. In addition, the increase 175,000 jobs added beat expectations and was more than the previous month – indicating that adverse weather likely depressed previous employment reports this winter. I speculate that the strong February employment report will encourage the Federal Reserve (Fed) to continue tapering.

I believe the Fed might find this an opportune time to adjust forward guidance, but I am not sure how they will do it. According to the Wall Street Journal, “A more vexing challenge for the Fed will be fine-tuning its official policy statement, which is loaded with assurances of low-interest rates in the future”. With the exception of the February employment report, the unemployment rate has been falling consistently. The Fed has already stated that it intends to keep rates low even after the unemployment rate falls below the 6.5% threshold. As I have mentioned before, the Fed might want to consider nominal gross domestic product (GDP) targeting.

However, I do not expect the Fed to announce nominal GDP targeting because it would be too much of a surprise. The Fed’s dual mandate includes unemployment and inflation, which means these two indicators will remain important (perhaps this can be legally changed one day). According to the Wall Street Journal, “[Janet Yellen] and other top officials have suggested a new statement could emphasize the Fed’s interest in a broad array of indicators, rather than a single unemployment indicator”.  Although I do not know what array of indicators they will choose, I believe this is a good first step. I think it would make sense for Yellen to choose a large selection of indicators that provide a sense of financial stability. Financial stability should be an explicit factor for interest rate decisions. Regardless of what indicators Yellen mentions, I am sure she will state that interest rates will stay low for awhile.

Although the economic recovery has been disappointingly slow, the economic outlook is undeniably improving as confirmed by the February employment report. Reducing asset purchases to $55 billion per month should be a clear decision, however, adjusting forward guidance poses more issues.

(Revised) Public Perceptions of the Forward Guidance

In my recent posts (here and here), I have been writing on the FED’s forwards guidance program. To me, the forward guidance program is as interesting as the FED’s co-unconventional tool, the quantitative easing, is if not as powerful as it is. (Actually, I am interested in writing on the QE’s aggregate effect on the recovery, but it is scary stuff to touch on) The FED implements the forward guidance (or open-mouth-operation) program to inform the market on how long the FED will pursue the low interest rate policy and by doing so, it hopes to induce greater investment and consumption from firms and consumers through expected low short-term interest rate.

In their recent paper on the effects of forward guidance on the public’s perception, Sack et al. suggested two possible public’s interpretations of a change in the FED’s forward guidance program. Here, a change in the forward guidance program means an extension on the current low interest rate policy. This is exactly the case we are in right now, where the FED has created market expectation that it would raise the short term interest rate as the unemployment rate reaches 6.5%, but now it faces an apparent change in their forward guidance policy. According to the authors, the FED’s change in the forward guidance policy can get two possible reactions from the market.

First, the market could see the delay of an increase in short-term interest rate as a sign of  bad news. In other words, the private sector could interpret the FED’s move as a sign of a weak recovery because it believes that the FED extended the low interest rate policy due to recovery which is slower than the FED presumably forecasted when it set its former policy or the date of the increase in interest rate. Therefore, this change in the forward guidance can lower the private sector’s valuation of the recovery.  If the market indeed perceives the news this way, the extension on the low interest policy can’t create as large increase in the consumption and investment as the FED intended through the forward guidance. Since the the market’s expectation of the future interest rate has now lowered due to the sign of a weak recovery, the FED’s move to extend a promised low interest rate period cannot lower the market’s expectation of the interest rate any more.

The second way the public may interpret the change in the forward guidance is that it could think the FED extended promised period of low interest rate to “maintain a more accommodative policy position for a longer period for a given set of macroeconomic conditions.”  Unlike the first case, if the public indeed sees the longer period of low interest rate as the FED’s more aggressive stand on the recovery, the public expect the economy to recover sooner. In that case the, the effect of the forward guidance program on the investment and consumption will be greater since the FED’s promise to extend the low interest rate policy, in this case, lowers the market’s interest rate expectation which is raised by the news of the FED’s more accommodate policy and expectation of sooner recovery.

Therefore, to have a positive effect it initially hoped to have on the consumption and investment through the forward guidance program, the FED now has to tweak its forward guidance policy in a such manner that the public will see the change in the policy as a more accommodative policy rather than just a weak recovery fix.

The BOE and the FED both have had to change their forward guidance program to adjust to an unexpected quick drop in unemployment rates. The central banks primary goal regarding their forward guidance program should be now to either trick the market if their intentions of extended low interest rate is to boost a lower than expected recovery or convince the market if they extend the low interest rate policy to give more push to the economy even it is doing well.

I want to finish the post asking Ben Bernanke to summarize the points made on the market’s perception of the FED’s forward guidance in this post. Bernanke explained this two possible perceptions very clearly in his following statement made in 2012:

“Has the forward guidance been effective? It is certainly true that, over time, both investors and private forecasters have pushed out considerably the date at which they expect the federal funds rate to begin to rise; moreover, current policy expectations appear to align well with the FOMC’s forward guidance. To be sure, the changes over time in when the private sector expects the federal funds rate to begin firming resulted in part from the same deterioration of the economic outlook that led the FOMC to introduce and then extend its forward guidance. But the private sector’s revised outlook for the policy rate also appears to reflect a growing appreciation of how forceful the FOMC intends to be in supporting a sustainable recovery.”