Thursday, November 12, 2009

Anchoring interest rate expectations

In uncertain times like the present, where interest rates are ruling at historic lows, government deficits are mounting, and inflationary pressures (atleast in the medium to long term) remain a strong possibility, one of the more important goals of monetary policy making is to remove uncertainty about interest rate (and inflation) expectations. Central Banks have tried to approach this goal by making public statements to guide expectations about future short-term rates, with and without specifying clear time lines and/or rates (or rate ranges).

US Federal Open Market Committee meeting of August 12, 2009

"The Committee... continues to anticipate that economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period."

Bank of Canada's interest rate meeting on April 21, 2009

"Bank of Canada lowers overnight rate target by 1/4 percentage point to 1/4 per cent and, conditional on the inflation outlook, commits to hold current policy rate until the end of the second quarter of 2010."

Two economists from the San Francisco Fed have compared the experiences of both Canada and the US and find no evidence that market participants make distinctions between these statements and expectations generated by their respective policy implications. One of the fundamental challenges of central banking, especially in uncertain times, is to provide clear communication about "the expected path of short-term interest rates, which influences long-term interest rates today", which in turn plays a crucial role in investment and spending decisions. As the authors write, "the ability of central banks to influence the economy today depends upon their ability to shape market expectations about the path of policy rates in the future".

However, Central Bankers face a dilemma with their interest rate communications,
"Make an explicit statement that may have a substantial impact now with the risk of problems in the future, or avoid the risk and make a more cautious statement that may have only a marginal impact".

The authors compared the forward rates on interest rates of both US and Canada and assessed the two contrasting interest rate communication policy stances adopted by the respective Central Banks,

"We find little to suggest that the announcement of a fixed end date has significantly affected expectations of future monetary policy in Canada. It seems that market participants see little difference between the US phrase "extended period" and Canada's conditional commitment to keep rates fixed for a specified period."

In any case, both Central Banks' strong and explicitly made commitment to "promote economic recovery and preserve price stability", coupled with their strong credibility, may have had the effect of marginalizing the subtle differences in their interest rate communications. However, this may not be the case with other Central Banks who do not enjoy similar credibility and autonomy. In case of these Central Banks, the markets may find positive signals in more explicit targets during uncertain times.

Update 1
Nick Rowe has a nice analysis of the dilemmas facing Central Banks when they promise to keep nominal interest rates low for too long to escape a liquidity trap - output today Vs inflation in the future. He feels that a public policy communication to create a higher inflation (than what is the normal, and which in turn is clearly defined) in the future than it would want in future, in order to buy higher inflation, lower real interest rates, and higher output today may be more explicit than one that promises to keep the overnight rate near zero for an extended period, conditional on the outlook for inflation.

Update 2
Brad De Long suggested that the Fed fix an explicit inflation target of 3%, so as to lower the real interest rate and boost investment and consumption in the economy. Ben Bernanke replied by pointing to the "risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward".

Paul Krugman feels that the Fed should real interest rates by either itself buying long-term assets, driving down the wedge between short and long rates, or raise expected inflation, or do both.

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