Wednesday, May 22, 2013

"Forward guidance" as an instrument of monetary policy

I blogged earlier on why the extraordinary monetary accommodation by way of quantitative easing was like pushing on strings. Clearly the dramatically increased monetary base is inducing neither consumption nor investment. Heck, it is not even leaving the bank vaults!

Furthermore, the QE policies may be creating distortions across the world economy. Fundamentally, the co-ordinated monetary accommodation in US, Europe, and now Japan, has created a world awash with liquidity. This has resulted in massive resource mis-allocation problems. There are signatures of froth in bond markets in general and US government securities in particular. For the past year-and-half, in an apparent decoupling from their recessionary real economies, equity markets in US and Europe have been booming. The biggest beneficiaries have been the large financial institutions who have leveraged the plentiful cheap capital and gotten even bigger and ever more profitable.

Worse still, the ripples from these distortions have adversely affected the developing countries. Faced with low returns, volatile portfolio capital from developed markets has been flowing into the emerging economies. These capital inflows have driven up currencies and imported inflationary pressures. It has increased the risks associated with macroeconomic management for all these economies. And not to say anything about the possibility that the excess liquidity may have played its role in inflating the commodities market bubble which has adversely affected many developing countries.

In this context, I recently got to read Michael Woodford's compelling case laid out at Jackson Hole last year that favors monetary policy communication through "forward guidance" over QE. He advocated that the Fed scrap QE and communicate that it will do everything it can to keep nominal interest rates low till a certain economic (say, potential output gap is closed) or financial (say, inflation crosses a certain limit) outcome is breached. This will remove all uncertainties about abrupt policy reversals and reassure investors and consumers that the real interest rates will remain ultra-low for an extended period of time. In this way it will, unlike the QE, directly address the uncertainties that currently clog the investment-consumption channel.

He argues that the most effective strategy to frame expectations in a positive manner would be through a nominal GDP targeting regime. A signal that the Fed will persist with low rates till the economy recovers back to its trend output level removes all transitionary uncertainties and could credible commitment, without compromising its anti-inflationary bias, that would reassure and thereby restore the animal spirits in investors and consumers alike. He writes,
Standard New Keynesian models imply that a higher level of expected real income or inflation in the future creates incentives for greater real expenditure and larger price increases now; but in the case of a conventional interest-rate reaction function for the central bank, short-term interest rates should increase, and the disincentive that this provides to current expenditure will attenuate (without completely eliminating) the sensitivity of current conditions to expectations. If nominal interest rates instead remain unchanged, the degree to which higher expected real income and inflation later produce higher real income and inflation now is amplified. If the situation is expected to persist for a period of time, the degree of amplification should increase exponentially. Hence it is precisely when the interest-rate lower bound is expected to be a binding constraint for some time to come that expectations about the conduct of policy after the constraint ceases to bind should have a particularly large effect on current economic conditions — to the extent, that is, that it is possible to shift expectations about conditions that far in the future.
See this and this for excellent commentaries on the Woodford paper.

I have blogged earlier, here and here, examining both sides of the argument on the issue of NGDP level as a monetary policy anchor. On further reflection, the monetary policy framework can be made even more robust by communicating a two-level target. The Fed should clearly put forward its commitment to reach the desired NGDP level (recovery to the potential output level) over a 2-3 year time frame, while also seeking to signal its commitment to a medium-term (say, 3-4 years) inflation target of 2-2.5%. This should achieve the level targeting objective without compromising on the inflation fighting credibility.

Update 1 (7/8/2013)

The new Governor of Bank of England Mark Carney becomes the latest to embrace forward guidance strategy to increase the effectiveness of monetary policy. It announced (pdf here) that it intends to keep interest rates at 0.5% (where it has stood since March 2009) till unemployment rate, currently at 7.8%, falls to atleast 7%. This comes with three provisosone, if the MPC judges that inflation in around two years’ time will be half a percentage point or more above the 2% inflation target; two if medium-term inflation expectations “no longer remain sufficiently well anchored”; three, if the bank’s financial-policy committee judges that the monetary stance poses a significant threat to financial stability that cannot be contained by other measures that the bank can take. See analysis here

Update 2 (9/9/2013)

QE and other unconventional monetary accommodation can only get you so far. The more important thing is expectations management. Christina Romer has an excellent speech where she argues that dramatic change in expectations can come only from "regime shifts", of the sort that Shinzo Abe has been trying to do in Japan. 

Update 3 (9/9/2013)

Narayan Kocherlakota, President of the Minneapolis Fed, makes a strong case for forward guidance,
Over six years after the national unemployment rate first began its ascent, the labor market remains disturbingly weak. The good news is that, with low inflation, the FOMC has considerable monetary policy capacity at its disposal with which to address this problem. The FOMC’s test today is to figure out how best to deploy this capacity. The answer lies in taking two steps. The first step is to communicate that our goal is to accomplish a fast return to maximal employment while keeping inflation close to, although possibly temporarily above, the target of 2 percent. The second step is to do whatever it takes, on an ongoing basis, to achieve that goal. A goal-oriented approach to monetary policy greatly reduced inflation in the early 1980s. Adopting such an approach in our own time would improve labor market outcomes. 
Update 4 (11/9/2013)

Very nice article by Marcel Fratzscher who cautions against excessive reliance on the use of central bank communications to shape market expectations. He finds three drawbacks with the current dominance of central bank communication - it crowds-out other private sources of information, thereby thereby depriving the monetary authorities themselves of an invaluable, independent view of trends that they need for sound policymakingprice movements have come to reflect responses to their statements and actions rather than to changing economic and financial realities; when central banks are seen to give misleading assurances and to over-commit to certain outcomes, they risk losing their most important asset, their credibility. 

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