In a speech on November 13 at University California, Berkeley Fed Vice Chairwoman Janet Yellen provided a lengthy account of the recent evolution of Fed communications and transparency. Although sections of the speech about the necessary evolution of Fed transparency and the role inflation targeting plays in that should not be brushed aside, for those of us trying to prepare for possible changes in future policy, Dr. Yellen's support for inflation and employment oriented forward guidance, rather than date-certain guidance, provides essential information.
It is important to highlight that Vice Chairwoman Yellen did examine the possibility of providing broader market forecasts, rather than simplified guidance, but she determined this policy impractical with 19 policymakers all potentially providing differing forecasts. This line of reasoning as to why the Fed is unwilling to provide these detailed forecasts, as both the Swedish and Norwegian central banks do, indicates not that it is a bad idea, but that Fed officials fear they will not be able to control the flow of information to the public. So, a simpler policy is preferable.
As I have noted before, Fed officials typically prefer simpler over more complete policy communications. The epitome of simplicity over substance is the Fed's adoption of an explicit inflation target earlier this year. This move, to inflation targeting represented a shift towards rules-based monetary policy. Although these rules will necessarily need to be broken at some point, and breaking them potentially diminishes Fed credibility, they provide simple cover from political attacks on Fed policy.
The next step in rules-based monetary policy is changes to forward guidance as Vice Chairwoman Yellen detailed in her speech:
The Committee might eliminate the calendar date entirely and replace it with guidance on the economic conditions that would need to prevail before liftoff of the federal funds rate might be judged appropriate. Several of my FOMC colleagues have advocated such an approach, and I am also strongly supportive. The idea is to define a zone of combinations of the unemployment rate and inflation within which the FOMC would continue to hold the federal funds rate in its current, near-zero range.
She goes on to say:
I support this approach because it would enable the public to immediately adjust its expectations concerning the timing of liftoff in response to new information affecting the economic outlook. This market response would serve as a kind of automatic stabilizer for the economy: Information suggesting a weaker outlook would automatically induce market participants to push out the anticipated date of tightening and vice versa.
Perhaps more importantly, the use of inflation and unemployment thresholds would help the public understand whether a shift in the calendar date, assuming that one is still included in the statement, reflects a change in the Committee's economic outlook or, alternatively, a change in its view concerning the appropriate degree of accommodation. Since monetary policy works in large part through the public's perceptions of the FOMC's systematic behavior, this distinction is critical.
This account suggests that Dr. Yellen has conflated several issues. She has taken Chicago Fed President Charles Evans' proposal of guidance based at achieving 7% unemployment with no greater than 3% inflation as functionally equivalent to Minneapolis Fed President Narayana Kocherlakota's proposal for guidance based on achieving 5.5% unemployment with no greater than 2.25% unemployment. I contend that these two proposals highlight a crucial distinction. Evans' proposal is based on the fact that we are in a continued employment crisis so long as unemployment remains above 7%. Once we reach below that threshold, the rule is no longer relevant. Kocherlakota's proposal represents a long-term monetary policy rule. Since the Fed's own projections suggest that structural unemployment is around 5.5%, he is suggesting a combined inflation/unemployment target for the long-term.
Dr. Yellen's account also suggests that she assumes that unemployment and inflation numbers are a credible signal to the market. Given the vast media coverage of Jack Welch's response to the September employment numbers, I think it is fair to suggest that people are skeptical about the value of unemployment statistics. Plus, those that are knowledgeable about how these statistics are calculated understand that using such a benchmark is obviously an ill-conceived way to make policy, if it is your only employment data point. Moreover, since the Fed prefers to use core inflation rather than headline, many market actors tend to fundamentally disagree with the Fed's stated inflation numbers. So, while these numbers are reasonable benchmarks, any knowledgeable investor knows that the Fed takes into account far more data than these simple numbers when making a policy decision; this mere fact makes reduces the credibility and the value of forward guidance based on numeric employment and inflation targets.
The View From the FOMC
The minutes of the October FOMC meeting suggest that Vice Chairwoman Yellen is not alone in her growing support of numeric policy targets:
Participants generally favored the use of economic variables, in place of or in conjunction with a calendar date, in the Committee's forward guidance, but they offered different views on whether quantitative or qualitative thresholds would be most effective. Many participants were of the view that adopting quantitative thresholds could, under the right conditions, help the Committee more clearly communicate its thinking about how the likely timing of an eventual increase in the federal funds rate would shift in response to unanticipated changes in economic conditions and the outlook. Accordingly, thresholds could increase the probability that market reactions to economic developments would move longer-term interest rates in a manner consistent with the Committee's view regarding the likely future path of short-term rates. A number of other participants judged that communicating a careful qualitative description of the indicators influencing the Committee's thinking about current and future monetary policy, or providing more information about the Committee's policy reaction function, would be more informative than either quantitative thresholds or date-based forward guidance.
However, the minutes also suggest that several skeptics on the Committee pointed out some of the drawbacks to over-simplifying the complex nature of monetary policy, just to improve communication:
Several participants were concerned that quantitative thresholds could confuse the public by giving the impression that the FOMC focuses on a small number of economic variables in setting monetary policy, when the Committee in fact uses a wide range of information. Some other participants worried that the public might mistakenly interpret quantitative thresholds as equivalent to the Committee's longer-run objectives or as triggers that, when reached, would prompt an immediate rate increase; but it was noted that the Chairman's postmeeting press conference and other venues could be used to explain the distinction between thresholds and these other concepts.
Despite these qualms with changes to the forward guidance, the Committee also highlighted the potential pitfalls in releasing more substantial and valuable complete economic forecasts:
Participants agreed that FOMC communications could be enhanced by clarifying the linkage between participants' economic forecasts, including the underlying policy assumptions, and the Committee's policy decision as expressed in the postmeeting statement. However, most participants judged that, given the diversity of their views about the economy's structure and dynamics, it would be difficult for the Committee to agree on a fully specified longer-term path for monetary policy to incorporate into a quantitative consensus forecast in a timely manner, especially under present conditions in which the policy decision comprises several elements.
Given this pessimism over releasing genuinely valuable data in the form of economic forecasts and the growing consensus toward quantitative thresholds for forward guidance, it is clear that the next major step in Fed transparency is going to be the adoption of quantitative forward guidance. While I believe that this provides only marginally more information to the public than the simplistic, date-certain projections currently being used, I suspect it will be well-received. Investors will appreciate having a firm, data-based timeline for when policy will change, rather than an ambiguous date that keeps being pushed further into the future. Some uncertainty does remain about what thresholds the committee will set, but since it is likely easier to revise down (rather than up) unemployment and inflation conditions, I suspect they will initially set relatively high benchmarks, close to what Charles Evans has proposed.
The only remaining question is when the Fed will announce this new policy and cause a brief market rally. It is likely that sufficient support for the change in forward guidance already exists on the Committee, but Bernanke is looking for a solid majority with few or no dissenters. Given that the earliest and strongest supporter of this change to the Fed's guidance, Chicago Fed President Charles Evans, is a voting member of the FOMC in 2013 and he has already shown some acuity convincing other members of the value of this policy, I expect this to be a first order of business in the new year, just as Twist comes to a close. So, barring a catastrophic fiscal cliff situation requiring more significant Fed policy moves, investors should keep an eye out for a change in the Fed's forward guidance structure at the January FOMC meeting.