Tag Archives: forward guidance

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 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.

Screen shot 2014-03-24 at 12.00.01 PM

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.

 

The Fed Ties Interest Rate Raise to the Tapering Instead of Unemployment Rate

Following today’s Fed’s meeting, the meeting statement has been scrutinized by every word to word. Of course, the biggest headline news was the Fed’s move to drop the unemployment rate of 6.5% as a threshold rate for raising interest rate from its meeting statement. Not only are Fed watchers reading the statement literally word to word, but also some of the policymakers at the Fed worried that some paragraphs of the statement might stir the market to a wrong way. To be more precise, Minnesota Fed President Narayana Kocherlakota was the only voting member who voted against the Fed’s decision to remove the key number of 6.5% from the statement. He says that the a paragraph in the statement may signal the Fed’s weakness when it comes to reaching the long-term inflation rate of 2%. The paragraph he was referring to is following:

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 [emphasis added].

It seems like the last sentence could have caused Mr. Kocherlakota to vote against the action because of it’s  possible inference of a lasting low inflationary period. As low inflation has continued since 2012, inflation expectation, also, hasn’t been reaching the goal of 2%. The expected inflation in 10 years is still lower than 2%. The following graph provided by the Cleveland Fed shows the market’s expectation of inflation in certain time horizons :
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Considering the low expected inflation in next few years, Mr. Kocherlakota’s worry of weakening the credibility of the Fed’s commitment to the 2% inflation is indeed valid. The Fed’s main goal thorough its forward guidance is to lower the expected interest rate for certain duration, but it’s another goal from which the FED is quite away from reaching it is to raise the inflation expectation, which in turn lowers the real interest  rate and boost investment.

Now let me interpret the Fed’s statement in my way. The WSJ posts an interesting post on how the latest Fed’s statement changed from last month’s. The following passage shows the change made in the statement from last month:

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 well past the time that the unemployment rate declines below 6-1/2 percentfor 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. When the Committee decides to begin to remove policy accommodation, it will take a balanced approach consistent with its longer-run goals of maximum employment and inflation of 2 percent, and provided that longer-term inflation expectations remain well anchored.

As we see from the change made in the statement, the Fed untied the possible date of raising interest rate from the unemployment rate and related it more to the Fed’s tapering process and its ending. Now, the Fed watchers should be giving more weights to the tapering process than before since it is now more related to the raise in interest rate.

This change could be progress forward for the Fed because as the tapering continues for at least throughout 2014, the market will have stronger signal of the Fed’s raising interest rate in near future. Even though then higher expected interest rate might seem worse for the economy, raised expected interest rate could actually induce more investment today, which is opposite to what one might assume. Because, the market will be surely knowing the coming of the raise in the interest rate in few months, firms should take advantage of the low interest rate today by borrowing and investing rather than postponing the investment project. This idea of surely known interest rate increase could create more investment is explained in my one of the previous posts.

 

(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.”

 

 

 

Forward Guidance: Changes Must Be Made

The Federal Reserve needs to change forward guidance because we are nearing the 6.5% threshold for unemployment and the economy is not even remotely ready to handle higher interest rates. The steadily decreasing unemployment rate is due to the decline in the labor force participation rate and inflation remains very below target. In addition, the rapid rate of economic growth in the second half of 2013 was partly because of temporary factors including inventory accumulation and strong exports. In short, I do not think the economy has recovered fully and I believe most would agree with that. Thus, how should the Fed alter forward guidance to take all of this into account?

I think there are two main approaches the Fed could take, which is either quantitative or qualitative. On the one hand, a quantitative approach would involve a guidepost such as an exact threshold for the unemployment rate (i.e. 6%). On the other hand, a qualitative approach would seem more vague and less concrete. (i.e. “full” employment). Although a quantitative approach would provide more clarity, I think a qualitative approach provides more space for the Fed to maneuver monetary policy. Whether quantitative or qualitative, I think there should be some mention of financial stability and inflation as two critical factors influencing interest rate decisions.

I believe that financial stability should be a factor impacting interest rate decisions for a few reasons. First, the choppy beginning to 2014 demonstrates more volatility than we saw in all of 2013. Second, the financial markets are trading at high valuations. The current bull market started in 2009 and continues to make new records. For example, the S&P 500 index is 0.4% away from a new record. Third, corporate fundamentals do not seem to have caught up to financial valuations. Increased volatility combined high valuations without strong corporate fundamentals concern me significantly especially as the Fed continues tapering.

I think that inflation should be another factor guiding interest rate decisions due to the velocity of money. Although the money supply has grown immensely, the low velocity of money has prevented inflation. Furthermore, the very low velocity of money sends a concerning disinflationary signal. Disinflation slows purchasing at both the household and corporate level of the economy. Although I believe the Fed is extremely aware of this, I do not think there is much they can do about it. As we learned in class, the low velocity of money is caused by the guaranteed zero percent interest rate on paper currency. If the Fed was able to lower the interest rate on paper currency below zero, then the velocity of money would increase as businesses and households spend their money rather than save it. As a result, inflation would increase and the spending would help the economy recover faster.

Regarding financial stability, I am having trouble determining whether the increase in United States household debt is healthy or worrisome. According to the Wall Street Journal, “U.S. consumers late last year drove the largest quarterly increase in credit outstanding since the third quarter of 2007”. On the one hand, I think this could be incredibly simulative as household debt includes mortgages, credit cards, auto loans and student loans. Thus, the increasing level of debt is an indication of more consumer spending and perhaps even higher consumer confidence. For these reasons, I am tempted to interpret this to be a vital support for an incredibly weak economic recovery.

On the other hand, the large portion of the rise in household debt was due to student loans. Although student loans are crucial means for funding education, student loans have a relatively high default rate compared to other forms of household debt. Furthermore, the rise in student loans was mainly concentrated among those with weak credit ratings. According to the Wall Street Journal, “the nation’s sharp rise in student debt is being driven largely by Americans with poor credit”. As a result, a large amount of this new debt might not get repaid and this is would not help the economic recovery. The quarterly increase in household debt since 2007, however, this preceded the worst financial crisis since the Great Depression. In short, credit should be created with caution and this might not be the case with some parts of the recent increase in household debt.

I believe it is imperative for the Fed to change forward guidance because I think we will likely fall below the 6.5% unemployment threshold by the next jobs report. The Fed might want to restate the importance of the 2% inflation target (a qualitative guideline) and make an explicit qualitative guideline for financial stability as key elements surrounding interest rate decisions. I would be surprised if the Fed does not make any alterations to forward guidance at its next meeting.

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 effective 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 when how long the FED will pursue the low interest rate policy and by doing so, it hopes to induce greater investment and consumption from the firms and consumers through the 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 the change in the FED’s forward guidance program. Here, the 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 apparent slight 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 the increase in short-term interest rate as a 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 because the economy isn’t recovering as the FED presumably forecasted when it set its former policy or the date of the increase in interest rate. In other words, this change in the forward guidance can lower the private sector’s confidence in the recovery.  If this is indeed the case, the extension on the low interest policy can’t have a positive effect on the behavior of firms and consumers.

The second way the public may interpret the change in the forward guidance is that it could think the FED extended the low interest rate policy 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 more 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 positive.

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.

I want to finish the post asking Ben Bernanke to summarize the points made 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.”

 

 

 

Factors That Affect Effectiveness of Forward Guidance

The “forwards guidance” has been he FED’s one of the novel tools to boost the economy after the recession at the zero lower bound. Forward guidance is the FED’s public statement on how it will change or unchange the federal funds rate. We can see the latest forward guidance statement from the FED’s January statement:

Committee today reaffirmed its view that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the asset purchase program ends and the economic recovery strengthens. The Committee also reaffirmed its expectation that the current exceptionally low target range for the federal funds rate of 0 to 1/4 percent will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.

Essentially, what the FED tries to achieve by such statements is to guide the market expectation of the interest rate. The FED has been using forward guidance to lower the market expectation of interest rate during the period it stated.

I should explain two types of forward guidance as introduced by Campbell et al. (2012). Odyssean type of forward guidance is when the FED commits to low interest rate policy even after the economic condition raises the natural interest rate above zero, and Delphic forward guidance is when the FED publicly forecasts its monetary policy’s shape regarding the future shocks in the economy. We can see that the FED has been pursuing the Odyssean forward guidance since September 2012 because it publicly stated then that the the low interest rate policy would stay even after the economy strengthens:

To support continued progress toward maximum employment and price stability, the Committee expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens. In particular, the Committee also decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that exceptionally low levels for the federal funds rate are likely to be warranted at least through mid-2015.

Having talked the basics of the forward guidance, we should study further what factors play a role in effective forward guidance program. First, the FED’s credibility decides whether the forward guidance will achieve its goal of lowering the market expectation of interest rate.If the market doesn’t believe in the FED’s plan for the future interest rate, the forward guidance cannot stimulate the economy as the FED hopes. After all, what the forward guidance’s mechanism bases on is the FED’s policymakers’ hope that the market will take the FED’s statement on the future of the monetary policy as granted. Reports are coming in saying that the FED has lost its credibility since the FED is no way raising the federal funds rate even though the unemployment rate is very likely to reach 6.5% very soon. I can understand why this might distort the FED’s credibility. If we look at the FED’s October meeting’s press statement, following statement follows the same statement in the January statement above. October’s statement reads:

 …In determining how long to maintain a highly accommodative stance of monetary policy, the Committee will also consider other information, including additional measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments.

But in December, the FED added one more statement following the above statement. The added statement follows:

…The Committee now anticipates, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal.

From this change in the forward guidance, one can say that the FED didn’t follow what it forward guided previously. But to me, I don’t see any credibility problem for the FED. Didn’t the FED literally say in the above statement that it will more likely to extend the low interest rate even past the time unemployment rate drops below 6.5%? Didn’t the FED have to modify its stand on its future interest rate policy according to the economics condition? Therefore, seeing the FED as not committing to its forward guided policy is like saying the FED has one chance to state what the interest rate will be in the next few years, and if it doesn’t follow that, we cannot believe in the FED.

Rather, I think the FED faces credibility problem when it suddenly increases the interest rate when the unemployment rate lowers to 6.5% because current forward guidance tells us that the FED will very likely be pursuing near zero interest rate even after the unemployment rate hits the threshold.

Second factor that determines the effectiveness of the forward guidance is the public’s forecast of the recovery. If the public believes that the economy will soon recover, then the public naturally expects a higher interest rate in the future. In that case, when the FED successfully forward guides its low interest rate policy, the consumption and investment will increase because the FED has just lowered the public’s interest rate expectation. Hence, the firms and households are more likely to consume and invest more. On the other hand, if the public expects the economy to be still recovering from the recession in the future, it expects the interest rate to be lower as it is now. In that case, even the FED forward guides the economy by promising the persistence of low interest rate, the public’s decision on consumption and investment isn’t affected that much since its interest rate expectation isn’t changed.

The working paper by Gavin et al.(December 2013) concludes following:

The stronger the expected recovery, the more households believe the future nominal interest rate will rise and the larger the stimulative effect of forward guidance on current consumption. We find that news of a −50 basis point shock to the nominal interest rate next period leads to an increase in current consumption of about 0.20 percent.

In summing up the discussion, I believe the FED’s current forward guidance policy’s stimulative effect is still ambiguous considering the FED’s mixed signals on the economic outlook through its bond buying program tapering, which gives the market positive sign, and its reluctance to increase the interest rate even though the unemployment rate is almost at the threshold, which might worry the market. Interesting news to follow in next few months will be the FED’s next change in its forward guidance program.

 

PS. Should the FED and Mrs. Yellen not-forward guide the public as the Chicago Bulls and Derrick Rose do?

Thought on Forward Guidance: Proposal for the Fed

The FED has been pursuing its so called “forward guidance” program hoping it could stimulate economy by convincing the persistence of low interest rate policy. It stated that it sees the current low interest rate appropriate as long as the unemployment rate remains above 6.5% and the expected inflation in one to two years is below 2.5%. According to the statement, it will consider the broader labor indicators and inflation expectations to decide how long it will continue the near zero interest rate policy once the unemployment rate drops to 6.5%. Therefore, it is very up in the air when the FED is increasing the federal funds rate.

We know that the latest report shows the unemployment rate is 6.6%.  This rate indicates that even though the monthly net number of jobs added hasn’t been up to the projections for last two months, the FED will soon be deciding its future policy and writing up its well-into-future forward guidance once the unemployment rate hits 6.5%.

After all, the FED’s low interest rate policy has been directed toward increasing investment. But there could be different type of “forward guidance” that could potentially create more investment as the FED wishes. My proposal to the FED is that:

a) It should forward guide the market by putting hard deadline on when it is increasing the federal funds rate and therefore the market interest rates. How this clear deadline for increase in federal funds rate works is following: If the FED successfully (!) convince the market that it will indeed push up the federal funds rate, the investors will have clear expectation of when the overall market interest rates are rising. Therefore, realizing the higher investment cost in the specific future, firms will have incentive to borrow and invest today before the FED raises the interest rate. Hence, the investment could increase as the FED has been wishing. This argument is analogical to the people’s consumption when there is very high inflation expectation. If the expected inflation is very high, people would try to buy goods as soon as possible. But the one difference between these two analogies is we don’t know what interest rate is very high to be analogy to the high inflation rate.

One might say that then if there is higher demand for loanable funds because of this policy, the interest rate will rise in the loanable funds market. But we have to remember, the FED has control over overall interest rate in the economy (or I believe so), it will pursue its current near zero interest rate policy until the date it forward guided comes.

b) Again, to succeed in increasing investment, the FED must be able convince the market that it is indeed increasing the federal funds rate at that certain date, To convince the market, the FED should set the date to be in near future and interest rate minimally higher in first few periods and commit to what it said.

According to latest report, the expectation of the FED’s federal funds rate in June 2015 has lowered in a recent month. This might be showing that the FED’s forward guidance indeed successfully convinced the market that the FED will be pursuing near zero interest rate policy. If current forward guidance is indeed somewhat successful, I believe the proposed forward guidance could be also successful.

Remember, at the time when the FED sets the specific date to increase the interest rate, the interest rate will be still zero percent, therefore there will be no negative shock to the total investment.

The problem to implement this forward guidance is that the FED cannot surely know how bad or good the economy will be performing at the time of its forward guided date. The FED could announce its first date to increase the interest rate once the unemployment rate reaches 6.5%. If the FED chooses 3 months to increase the federal funds rate after the unemployment reaches 6.5%, it can study how the investment behaved during this 3 months when the market believes the increase in the interest rate is coming. If the sign turns out to be good, the FED can further implement this “hard deadline for minimal increase in federal funds rate” forward guidance.

December Employment Report: Implications for Monetary Policy

During the weekend, I looked a little further into the December employment report. In order to understand some of the more striking figures on the surface, I found it helpful to dig a little bit behind the numbers.

Let’s begin with nonfarm payrolls, which grew by 74,000. Not only is that number substantially below the expected gain of 200,000, but it is also the slowest pace in three years. The impact of inclement weather is considered to be an important factor. According to the Wall Street Journal, “An unusually high number of people said bad weather kept them away from work during the employment report’s survey period, suggesting cold and snow dampened the count”. However, taking a deeper look into the data shows that both weather-sensitive industries (i.e. construction and leisure) and non-weather-sensitive industries (i.e. business services and health care) registered poor results. In other words, there was restrained employment growth in weather-sensitive industries as well as non-weather-sensitive industries (If non-weather-sensitive industries outperformed weather-sensitive industries, then that would be another story). As a result, bad weather might not be a reasonable explanation for the significant miss on the downside in nonfarm payrolls.

Are the results of the report weak enough to suggest that the expansion is faltering? Hopefully, not. According to the Wall Street Journal, “[Federal Reserve Bank of Richmond President Jeffrey Lacker] said economists typically don’t view data from a single month as indicating whether the economy is shifting into a higher or lower rate of growth”. I find myself agreeing with Mr. Lacker. Nonetheless, the weak report raised doubts about emerging views that the recovery is gaining momentum.

Now let’s consider the drop of 0.3% in the unemployment rate to 6.7% (an unexpected improvement). A primary cause of the drop in the unemployment rate was due to individuals leaving the workforce. According to the Wall Street Journal, “The labor-force participation rate – the proportion of people 16 and over either with a job or seeking one – fell to 62.8% from 63%. If it had remained stable, the unemployment rate wouldn’t have budged”. Consequently, frustration among potential workers rather than fundamental improvement was the driving force behind the lower unemployment rate.

If you feel that the miss in nonfarm payrolls is significant enough to warrant concern about the health of the U.S. economy, then you might expect the Fed to reconsider its decision to taper. When you compound that feeling with the decline in the labor-force participation rate, you might become truly frightened for the U.S. economy. Federal Reserve Bank of Richmond President Jeffrey Lacker said Friday, “Federal Reserve officials are likely to consider another reduction in their bond-buying program later this month, despite Friday’s weak jobs report”. Not only do I agree with Mr. Lacker, but I think it is what most investors are expecting. Hypothetically, what if the Fed retreated on their decision to taper (and added to QE)? I think investors might sell because it would imply that the Fed is questioning the health of the economy. On the contrary, some investors might take it as a comforting notion indicating that the Fed is willing to be incredibly accommodative in providing liquidity and helping restore economic growth (after all, the Fed’s decisions going forward will be both an art and a science).

The difficulties interpreting this decline in the unemployment rate might encourage the Fed to reduce its threshold for the unemployment rate to 6% from 6.5%. According to the Wall Street Journal, “Nobody will be surprised if the Fed further reins in its bond-buying program when it meets later this month. But it may offer a dovish take on how much labor-market improvement it will need to see before raising short-term rates – something investors aren’t yet prepared for”. I think the Fed would be wise to revise their threshold for the unemployment rate especially when considering what is moving that number. Reaching the threshold is a prerequisite for talks about raising the interest rate target. It looks like we are set to reach that threshold soon and not for the right reasons (i.e. an improving economy). Due to the importance of forward guidance in maintaining expectations, I think it is important for the Fed to lower the threshold for UE and communicate a low interest rate policy.