- Forward guidance should not be seen as a way to misguide markets.
- As cheap talk, forward guidance is a costless way to coordinate the actions of the private sector.
- Hence the Fed should be trusted in its endeavor to reach the best equilibrium.
Cheap is often synonymous with poor quality. Hence, using the term cheap talk for monetary policy could be considered a low-tier economic policy tool. Yet, in economic theory, forward guidance is considered cheap talk when there exists several possible outcomes or equilibria. It is a cost-free method for the Central Bank to indicate which path it would favor for the economy, unemployment and productivity. Such an approach suggests that there is not such a thing as a "natural rate" for many macro variables, the unemployment rate and the Treasury yield in particular. Cheap talk should be seen as a coordination device between the private sector and the central bank to ensure that accommodation remains until the economy has reached a desired level (no longer a "natural" or "normal" level). This is clearly what the Fed suggests when it states that there is "evidence of supply-side damage in the wake of the financial crisis" and that lower productivity and higher unemployment leave the "implications for future growth quite uncertain."
Cheap talk is not necessarily "cheat talk" as, contrary to what was thought in the past, the central bank does not always have an incentive to mislead the private sector to have better outcomes. This was clearly the background of the famous Barro-Gordon model of 1983 that opened the door to the statutory independence of central banks. In its simplest expression, the model suggests that the central bank has an incentive to deliver a higher rate of inflation, above the one that prevails during the wage setting negotiations. The lower real wage will bolster growth but provide some time inconsistency to the conduct of monetary policy. The end game is a structurally higher level of inflation. Independent central banks with a strong focus on inflation was the template of the Great Moderation. But as the crisis has shown, price stability was not a sufficient condition for financial stability.
In today's economics, the incentives of both the private sector and the central bank tend to converge. In addition, today's economies are facing the high risk of multiple equilibrium:
i. In the US the growing net saving of businesses could lead to a lack of investment spending and put the recovery in jeopardy;
ii. In Japan, the failure of Abenomics to push real wages higher could send the economy back into stagnation;
iii. In the Eurozone, the failure to fix the banking system could accentuate the fall in potential growth for lack of a genuine increase in capital per capita;
iv. In the UK, the failure of productivity to recover might have been driven by a more "humane" way of dealing with the workforce (against pay freezes), but it could clearly hinder any potential rise in productive investment.
Those examples suggest that there might be a common objective for the public and the private sector but, as game theory suggests, there might be some sub-optimal equilibrium. Hence the need for forward guidance for coordination purposes.
The table below is inspired by a recent working paper by Miller and Zhang (CEPR 9975). The signs in the brackets are the favored outcomes for the private sector and the central bank according to a ranking that goes from double minus to double plus. By convention I use (private sector; central bank) in the payoff presentation. This kind of presentation is very familiar to users of game theory templates. For non-familiar readers, each case represents the "payoff" for both "players" according to the "state of the world" defined by the respective levels of repo rates and productivity gains.
The table shows two things:
i. There is one favored pair: low policy rates and high productivity (goldilocks);
ii. But there are two other situations when there is no incentive for at least one player to move away from this situation. For instance in the stagnation situation the private sector could benefit from lower policy rates but it would increase the inflation risk and reduce the "utility" of the central bank.
This simple template suggests that there is an incentive for both economic agents to reach the (++ ;+) equilibrium and that it is of the utmost importance for the central bank to reach the below right case. This has implications for the conduct of monetary policy:
i. If the Fed is not trying to "cheat" the public with cheap talk (that is, costless forward guidance), the 4% target for Fed Funds in the medium run should be considered a policy tool to incentivize the private sector to increase productivity through stronger capex;
ii. It could also mean that in such a scenario the Fed would clearly not overshoot given that high productivity gains are the best recipe for low inflation;
iii. It should not mean that the neutral level for the U.S. Treasury yield should be revised sharply downward since, as can be seen on the chart, periods when 10-year yields were much higher than Fed Funds rarely happen.
Bottom Line: Forward guidance might be cheap talk in the sense that it is a free way of trying to solve a coordination problem. Of course, there might be contingencies that would force the central bank away from its preferred path. But contrary to what theory suggested in the early 1980s, modern central banking is not about cheating, but coordination.