Why The Fed's Long-Term Interest Rate Forecast May Backfire

by: David Beckworth

The Fed is about to release it first long-term interest rate forecast. Gavyn Davies explains how this could enable U.S. monetary policy to add more stimulus without actually expanding its balance sheet. It would do so by managing nominal expectations. Here is Davies:

What is the motivation behind these changes? Mr Bernanke has normally justified such steps in terms of stabilising expectations about the Fed’s genuine intentions, especially on inflation and the forward path for interest rates. At a time when the extension of the balance sheet is causing political difficulties for the Fed, and when inflation expectations could become unhinged by the rapid expansion of the monetary base, the chairman is looking for alternative ways of easing monetary conditions without printing more money. Modern macro-economics suggests that operating on expectations is one of the most powerful tools available to him, though he is using it much more cautiously than many economists would like to see...

[T]he new mechanism will provide the Fed with a potentially important tool to influence expectations, and therefore the course of the economy. Paul Krugman was the first to argue in the 1990s that, in the modern version of the liquidity trap, an economy could get stuck permanently with high unemployment because of undesirable expectations of deflation. With short rates not able to drop below zero, the real rate of interest could be too high to equilibrate savings and investment in the economy, so the normal monetary route back to lower unemployment might be blocked. The answer, said Krugman, was for the central bank deliberately to increase the expected rate of inflation, and therefore to cut the real rate of interest while nominal short rates were fixed at zero.

That is how the Fed hopes it will turn out. I think it will backfire because what observers really need is to know where the expected path of the federal funds will be relative to the expected path of natural (or equilibrium) federal federal funds. Here is what I said about this previously:

The FOMC lowering its expected path of the target federal funds rate, however, might also be interpreted as the Fed revising down its economic forecast and adjusting its target interest rate forecast accordingly to maintain the current stance of monetary policy. In other words, a lower long-term interest rate forecast might simply be viewed as the Fed expecting the natural interest rate to remain depressed longer than previously expected and thus needing to hold down its target federal funds rate target longer than expected. Here, the Fed would not be adding stimulus, but maintaining the status quo as the economic outlook worsened. Given the Fed's failure over the past three years to add sufficient stimulus to restore robust nominal spending and close the output gap, this less favorable interpretation in the current environment would amount to more passive tightening.

Gavyn Davies also recognizes another problem with using this policy innovation to steer monetary policy via expectations management: it may not be credible. Credibility, however, would not be a problem if the Fed would set an explicit nominal destination. Doing so would avoid the time inconsistency problem that concerns Davies. From my same post:

That there could be different interpretations of the Fed lowering its long-term forecast for the target federal funds rate speaks to a more fundamental problem with this new policy: the Fed has failed to set an explicit nominal target for monetary policy. Not knowing where the Fed is ultimately heading makes it difficult to interpret changes in the FOMC's long-term interest rate forecast. It is like a captain of a ship who navigates by focusing on the rudder, but fails to set a destination point. It would be far better for the captain to pick his target destination and then adjusts the rudder accordingly. This is why it is so important for the Fed to set a nominal GDP level target. It would provide a clearer road map of where the Fed wants the nominal economy to go and it would make interpreting changes in the expected path of interest rates easier, if not redundant. It is time for the Fed to focus on the destination.

Okay, so the Fed is not likely to announce a NGDP level target tomorrow. I do wish, though, that it would also provide the expected path of the natural federal funds rate on its long-term interest rate forecasts. If so, it would help the public better understand the implications of the FOMC's expected path of the federal funds rate.