An explanation of forward policy guidance at the Federal Reserve
By John C. Williams, President and Chief Executive Officer, Federal Reserve Bank of San Francisco
Editor’s note: Credit Writedowns Pro users should also reference last months articles “Tapering and the shift from QE toward forward guidance” and “More on the Fed’s haphazard move to forward guidance over QE” for more detailed background discussion on this topic.
The Federal Open Market Committee has used various forms of forward guidance to influence the views of businesses, investors and households about where monetary policy is likely to be headed. This column by the President of the San Francisco Fed presents his views on the benefits, limitations and future role of forward policy guidance.
In response to the financial crisis, the Federal Open Market Committee (FOMC) lowered the target federal funds rate to essentially zero in December 2008, where it has remained. The economy, however, was still reeling, and it wasn’t possible to create additional monetary stimulus by cutting the federal funds rate further—owing to the inability of nominal interest rates to fall much below that point.
The FOMC therefore turned to “unconventional” monetary policies, including forward policy guidance. Through the use of forward guidance, the FOMC influences business and investor views about where monetary policy in general, and the federal funds rate in particular, is likely headed. This affects longer-term interest rates, as investors adjust their views on future short-term rates. In particular, we have used the Fed’s communications tools—policy statements, FOMC participants’ forecasts, press conferences, and speeches—to convey our expectation that short-term interest rates will remain low for some time.
The FOMC experimented with forward guidance in the past—in 2003 and 2004—and made a renewed effort in December 2008, when the FOMC stated that it expected to keep the funds rate low “for some time.” Although this qualitative forward guidance succeeded in influencing the public’s expectations of future policy, nonetheless, public expectations often remained much tighter than the FOMC’s own views. In fact, from 2009 to mid-2011, expectations from financial markets consistently showed the federal funds rate lifting off from zero within just a few quarters. This view persisted despite the efforts of many FOMC members to communicate the need for a sustained period of highly accommodative monetary policy, necessitated by the severity of the downturn and the slow recovery.
To push back against these excessively tight policy expectations, the FOMC shifted its forward guidance to make it more explicit. This occurred in the summer of 2011, offering a real-world example of the influence more assertive guidance can wield. At the time, many private-sector economists still believed that the federal funds rate would be raised within the year. By amending the language in its August statement—specifically, by writing that economic conditions were “likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013”—the Fed was able to communicate its expectation that liftoff from zero would take at least two years. The communication allowed us to bring public expectations into closer alignment with Fed thinking. As a result, longer-term interest rates fell by 10 to 20 basis points—a significant drop.
In December of 2012, we introduced a new form of forward guidance. Instead of speaking in terms of dates on the calendar, we began to tie the path of monetary policy to economic variables such as the unemployment rate. Specifically, the statement read that the FOMC “currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6½ percent.” This shift was undertaken with the intent of helping the public better understand the Fed’s decision-making process in response to changes in economic conditions. The caveat being, of course, that the public should not infer that reaching the quoted unemployment level would spark an immediate policy change; hence the wording, “at least as long as.” That is, this 6½ percent threshold is not an automatic trigger; it is merely a line of demarcation, after which we will reassess the most fitting course for the federal funds rate. For example, my own current projection—even though I expect the unemployment rate to fall below 6½ percent in early 2015—is that it won’t be appropriate to raise the funds rate until well after that point is reached, likely sometime in the second half of 2015.
This leads me to another form of forward guidance, the FOMC participants’ projections for coming years. Four times a year, FOMC participants submit their views on the appropriate future path of the federal funds rate, along with associated projections for economic growth, unemployment, and inflation. These projections are published on the Federal Reserve Board’s web site. At our most recent meeting in September, a substantial majority of FOMC participants—14 of 17—expected that the first funds rate hike would take place in 2015 or later. After the initial hike, most predicted future rate increases would occur only gradually, with the median projection that the funds rate would rise to just 2 percent by the end of 2016.
Again, these projections improve public understanding of Fed thinking. In addition to helping people better predict how the Fed reacts to changes in economic conditions, establishing this range of projections reinforces that the future path of policy is determined not by a preset course, but by how economic events unfold. This helps reduce the uncertainty and confusion we’ve historically seen as a result of public misperceptions of Federal Reserve monetary policy.
While forward guidance brings with it a number of benefits, it is also necessary to acknowledge both its limitations and some potential drawbacks. First, efficacy depends on credibility. In severe downturns, the likes of which we have recently experienced, appropriate forward guidance can stretch years into the future. Public credulity may be tested by statements relating to events so far off, particularly when policy makers may be different than the ones making assertions today. Second, clearly communicating monetary policy and the associated data dependence is difficult to do well. Asset-price fluctuations over the past several months, sparked by Fed communications, demonstrate how hard it is to effectively convey FOMC policy plans in an evolving economic environment. Just as good communication can reduce confusion and enhance the effectiveness of monetary policy, poor communication can do the opposite. Third, there is a danger of creating an over-reliance on Fed communication. While we want to convey our expectations and intentions, we want to avoid the public substituting independent thought with an attempt to read the Fed tealeaves.
Those issues notwithstanding, I expect that forward guidance will continue to play a central role in Federal Reserve policy in coming years. While the U.S. economy has been improving over the past four years, the unemployment rate stands at 7.3 percent, still substantially above its natural rate, which I estimate to be about 5½ percent. Additionally, inflation has been running persistently well below the Fed’s preferred goal of 2 percent. Under these circumstances, monetary policy is appropriately very accommodative and will continue to be for quite some time. Of course, as the economy continues to strengthen, the unemployment rate drops, and inflation gets closer to our ideal level, the stance of monetary policy will need to be normalized.
Once that occurs, I see a continued role for some aspects of forward guidance. The introduction of FOMC policy projections reflects a shift toward greater transparency about the future of the federal funds rate. Coupled with the new emphasis on providing an economic basis for forward guidance, this should result in greater public understanding of Federal Reserve policy and the reasons driving policy decisions. This, in turn, should reduce households’ and businesses’ uncertainty and help them make better borrowing and investment decisions, ultimately making monetary policy more effective.
Author’s note: The views presented in this article are the author’s alone, and do not necessarily reflect those of other members of the Federal Reserve System.
Rudebusch, G D and J C Williams (2008), “Revealing the Secrets of the Temple: The Value of Publishing Central Bank Interest Rate Projections”, in J Y Campbell (ed), Asset Prices and Monetary Policy, Chicago: University of Chicago Press, pp. 247–284.
Williams, J C (2013), “Will Unconventional Policy Be the New Normal?” FRBSF Economic Letter 2013-29, 7 October.
This article first appeared on Vox.