Tuesday, June 7, 2016

Fischer on Woodford on Forward Guidance

As we approach next week's FOMC meeting, it's worth reflecting on comments Stanley Fischer offered a few weeks ago at a conference honoring Michael Woodford. On the topic of forward guidance, Fischer noted [emphasis mine]:
At the ZLB [zero lower bound], explicit forward guidance can potentially offset a lot of the distortion, by, in effect, reducing all interest rates across the maturity spectrum at least up to the time that policy changes. Indeed, as shown by Eggertson and Woodford (2003), optimal forward guidance should commit to maintain lower interest rates during the recovery than would otherwise have been warranted by economic conditions. Importantly, the appropriate commitment can be framed as a history dependent policy function responding only to the history of the price level and the output gap, in such a way that the impact on policy decisions of economic conditions at the lower bound continue, even as the economy recovers.
For further explanation , it's worth quoting from Eggertson and Woodford:
...the private sector must be convinced that the central bank will not conduct policy in a way that is purely forward-looking, i.e., taking account at each point in time only of the possible paths that the economy could follow from that date onward.
And from Woodford's influential 2012 Jackson Hole paper:
In the case of forward guidance, it has been tempting for central bankers to believe that they can affect financial conditions simply by offering forecasts of likely future policy, while not really tying their hands with regard to future policy decisions. But instead, I shall argue that the most effective form of forward guidance involves advance commitment to definite criteria for future policy decisions
Later in the same paper:
In practice, the most logical way to make such commitment achievable and credible is by publicly stating the commitment, in a way that is sufficiently unambiguous to make it embarrassing for policymakers to simply ignore the existence of the commitment when making decisions at a later time.
Now consider the language the FOMC has been using in this regard (from the 27-Apr-16 Statement):
The Committee expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate; the federal funds rate is likely to remain, for some time, below levels that are expected to prevail in the longer run. However, the actual path of the federal funds rate will depend on the economic outlook as informed by incoming data.
Consistent with Woodford's analysis, FOMC members suggest the policy rate is likely to remain below long-run levels for some time. But they also inform us that policy depends on incoming data. Contrary to Woodford's advice, there's nothing history-dependent in FOMC guidance. This seems nothing more than a forecast of future economic conditions. And there's no obvious reason for market participants to believe FOMC members are particularly good at forecasting future economic conditions.

This raises a number of questions:
  1. Which form of forward guidance do FOMC members see as having been employed -- the innocuous forecasts about which Woodford warns, or the history-dependent version that requires keeping policy rates lower than they would be were FOMC members following a purely forward-looking policy?
  2. If the latter, do current FOMC members feel bound by policy commitments made by a previous FOMC?
  3. If current FOMC members do feel an obligation to follow a history-dependent policy, are they likely to honor this obligation -- or are they hoping that market participants have short memories and that any damage to their credibility would be relatively limited and short-lived?
  4. If they decide to follow a history-dependent policy, will they manage to communicate this effectively to market participants?
  5. And if they do follow a history-dependent policy, will they gain credibility in the eyes of market participants for maintaining a consistent commitment, or will they lose credibility with market participants for falling behind the curve?
My sense is that most FOMC members are either unaware or unappreciative of the distinction between history-dependent policy and purely forward-looking policy. And those that appreciate the distinction (eg, Fischer) probably believe most market participants are either unaware or unappreciative of the distinction. As a result, they probably perceive that their credibility is more likely to suffer in the event they allow themselves to get behind the curve than in the event that they fail to keep the policy rate lower than they would otherwise in order to maintain consistency with an earlier policy of forward guidance.

That's not to say that many of these members won't argue for a low-rate policy for other reasons. For example, given that the inflation rate has been below target for years, there are a number of reasons (eg, real debt burdens) that they might prefer a period of above-target inflation. But it seems unlikely that history-dependent forward guidance will feature among these reasons for keeping rates low.

Having said that, Fischer was quite explicit about history-dependent policy in the comments cited above. Could this be his way of "publicly stating the commitment, in a way that is sufficiently unambiguous to make it embarrassing for policymakers to simply ignore the existence of the commitment when making decisions at a later time?" And though Yellen's recent comments didn't include references to history-dependence, they did result in a re-evaluation among market participants about the likelihood of a further rate hike at next week's meeting.

Beyond this rate cycle, comments regarding forward guidance are important because they'll likely serve as precedent for policy the next time the zero lower bound is reached. And given the nature of the current recovery, it seems likely that the next recession, whenever it comes, will confront FOMC members yet again with the zero lower bound.