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 powerful tools for impacting economic conditions at the zero lower bound: forward guidance.
Forward guidance describes 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 increases investor confidence because investors know that interest rates will not increase until unemployment hits 6.5%. With a good estimate of future interest rates, investors feel safer making investments now. In turn, this heightened level of investment increase economic output and accelerate economic recovery.
Forward guidance is not a new tool. In the 1990’s the Bank of Japan promised to keep interest rates at zero “until deflationary concerns subside.” In the United States, 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 decisions), the zero lower bound necessitates its use even today. Unable to lower short-term interest rates to their necessary, negative rate, forward guidance allows the Fed to impact long-term rates and long-term risk tolerance in an effort to stimulate the economy.
That said, recent debate has me worried about the legitimacy of forward guidance. 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 this 6.5% unemployment is achieved, the Fed should raise interest rates and keep its promise. However an intriguingly titled Wall Street Journal article caught my eye this morning. With the title “Grand Central: As Unemployment Falls, Fed Doves Pivot to Low Inflation Concern,” this article had me concerned as to whether the Fed will actually keep its promise to raise interest rates once 6.5% unemployment is reached.
The article notes that some Fed doves are concerned about low inflation rates. In 2012, the Fed targeted an annual inflation rate of 2%, but in reality has only generated inflation of 1.3%. As shown in the graph below, this discrepancy in rates has caused a discrepancy between predicted price levels and actual price levels. Many doves support the continuation of low interest rates so as to boost short-term inflation above 2% and bring actual price levels in line with predicted price levels.
Personally, I have two issues with this decision. The first relates to the motivation for boosting inflation to match actual and predicted price levels. I agree that inflation can be helpful in the face of the zero lower bound by allowing for negative real interest rates and increased economic investment. That said, once the Fed reaches its 6.5% unemployment target, its goals have been met, and 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 promises.
Which brings me to my second and more important issue with this decision: it undermines forward guidance, thereby challenging the trustworthiness of the Fed and potentially eliminating a powerful 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 at 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) are like me, they will also lose trust in the Fed, thereby eliminating forward guidance as policy tool.
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 goals of central banks. Today, 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, there will always be debate as to which metrics the Fed should target. And I think there should be. The Fed should not pick a single goal, but rather should address each economic situation individual to respond optimally.
For this reason, I believe forward guidance, while powerful, is a ridiculous economic tool. It locks the Fed into a long-term strategy and inhibits its ability to respond to unanticipated changes in economic conditions. Interestingly, the elimination of the zero lower bound would eliminate the need for forward guidance. As such, I believe that addressing the zero lower bound should be a key priority for the Federal Reserve, as the Fed’s current need to use forward guidance hinders its ability to do its job well.