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September 30, 2016

From the Vault: Does Forward Guidance Work?

In recent months, there have been some high-profile assessments of how far the Federal Reserve has come in terms of communicating about monetary policy since its “secrets of the temple” days. While observers say the transition to greater transparency “still seems to be a work in progress,” they note the range of steps the Fed has taken over the years to shed light on its strategy, including issuing statements to announce and explain policy changes following Federal Open Market Committee (FOMC) meetings, post-meeting press conferences and minutes, FOMC-member speeches and testimony, and “forward guidance” in all its variants.

The evolution to openness stems from a theoretical argument that central banks can enhance the effectiveness of monetary policy by projecting a path for the federal funds rate and then clearly communicating how changes in the economic outlook might alter it. That sets up an expectations dynamic where households and businesses can “count on” the Fed’s responses to new developments. In a climate of easing, markets would react by driving down long-term interest rates on the expectation that the Fed will lower the policy rate, thus doing the “heavy lifting” to bolster the economy.

Several posts on Liberty Street Economics take note of the tools and approaches that economists use to measure the potential and effectiveness of forward guidance. For example, Richard Crump, Stefano Eusepi, and Emanuel Moench take advantage of a real-world laboratory created by an FOMC meeting in August 2011 when policymakers notably altered guidance. (The post-meeting FOMC statement shifted from saying economic conditions warranted an exceptionally low policy rate “for an extended period” to a more specific date “at least through mid-2013.”) Their analysis exploits the timing of surveys in a narrow window just before and after the meeting to show, among other things, that professional forecasters changed their expectations for monetary policy “considerably” and in a manner consistent with the language in the FOMC statement.

In another post, the same authors examined what happened to both market- and survey-based measures of the path of future interest rates in the wake of a June 2013 FOMC meeting. Interestingly, financial market measures (for example, the two-year Treasury yield and a key forward rate) shot up just after the meeting, while professional forecasters’ expectations remained steady. Our bloggers say forecasters “did not interpret Fed communication around the FOMC meeting as signaling a change” in the likely path for the federal funds rate (FFR). Instead, the behavior of rates was attributable to rising term premia, a measure of interest rate risk receiving heightened attention in research, policy discussions, and central bank communications.

Elsewhere on the blog, our economists explained how they use DSGE (dynamic stochastic general equilibrium) models to estimate the effects of forward guidance on macroeconomic variables such as GDP growth, core PCE inflation, and the federal funds rate. A simulation outlined in the post in which the FOMC committed to extending the “liftoff” date of the FFR for two quarters had “implausibly” large effects, including a sharp spike in GDP growth over the next two years, the authors found. But experimentation with a more realistic upper bound on the response of the long-term bond yield showed that “a policy-driven shift in in FFR market expectations . . . would have sizable, though reasonable, effects on GDP growth but only a modest impact on inflation.”

That the initial simulation drove such a large change in GDP remains “a forward guidance puzzle,” the authors said. Nonetheless, they argue that DSGE models, even with their limitations, are useful to policymakers in trying to estimate the potential effects of their interventions, “particularly when alternative approaches are lacking.”

Reading List
Making a Statement: How Did Professional Forecasters React to the August 2011 FOMC Statement?
Richard Crump, Stefano Eusepi, and Emanuel Moench

Preparing for Takeoff? Professional Forecasters and the June 2013 FOMC Meeting
Richard Crump, Stefano Eusepi, and Emanuel Moench

The Recent Bond Market Selloff in Historical Perspective
Tobias Adrian and Michael Fleming

The Macroeconomic Effects of Forward Guidance
Marco Del Negro, Marc Giannoni, and Christina Patterson

The views expressed in this post are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author.

Anna Snider is a cross-media editor in the Federal Reserve Bank of New York’s Research and Statistics Group.

How to cite this blog post:
Anna Snider, "From the Vault: Does Forward Guidance Work?," Federal Reserve Bank of New York Liberty Street Economics (blog), September 30, 2016,
Posted by Blog Author at 07:00:00 AM in DSGE, Expectations, Fed Funds, Forecasting, Inflation, Treasury

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"Guidance" about the future course of the federal funds rate seems bound to be confusing, as it is contingent both on future events and the uncertain reaction of the central bank to those events. It would seem to work only when the economy was on and remained on the "equilibrium" path that the central bank prefers. In addition, it seems implicitly to assume that the federal funds rate is the only policy instrument available to the central bank and that the central bank can (and is willing to) set it at any level. It thus seems to ignore the "zero lower bound."

Guidance about future policy would seem to be better conveyed by specifying, if only qualitatively, the reaction function with respect to some outcome, for example the price level. If the price level in period t is less than the target level, market participants could confidently expect that the central bank would take action -- changes in the federal fund rate, changes in the interest paid on reserves, changes in its balance sheet of long dated bonds, changes in purchases of foreign exchange denominated assets, or other policy instruments that it might use -- to raise the price level.

To use an analogy, "guidance" to the passengers about how driver will turn the steering wheel would seem to be better specified by a rule that the car will always be within a lane than by a series of left, right turns of the steering wheel before the curves in the road ahead are seen.

You probably don't receive many comments from non-economists so here is one from Control System Engineer.
The Federal Reserve is part of very complex system with negative and positive feedbacks. What makes such a system especially difficult to control are inherent delays in feedback loops (time it takes for the economy to respond to Fed decisions). The delays in feedback loops are very challenging issue in control system design and are most likely cause of instability. So to keep my remarks not too technical, the "noise generated by FOMC decisions" (which drives media and some investors crazy) is actually making the whole system more accurate and stable.
Considering the complexity of the system, the more open Fed does remarkable job.

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