As expected, FOMC participants continued their discussion of the framework review at the October meeting. At the September FOMC meeting, participants had focused on proposals for revisions in the policy strategy, including the potential for makeup strategies. At the October meeting, the discussion turned to tools: It was principally a review of the costs and benefits of unconventional tools in providing stimulus. Presumably, they were options that could be used if the fund’s rate became constrained by the effective lower bound (ELB).
The discussion also covered interesting issues that apply to both forward guidance and LSAPs. Perhaps the most interesting discussion was about potential innovations in forwarding guidance and tools that were not used in the U.S. in the post-financial crisis period, including capping rates and lending programs to facilitate the flow of credit. Most surprising was the consideration that participants gave to negative interest rates. To be sure, they still don’t see it as an attractive option. But it seemed to have been taken off the table some time ago, so the fact that they still wouldn’t rule it out marks a surprising amount of openness.
Let me start by identifying several issues that are relevant to unconventional policies, particularly forward guidance.
First, participants need not identify which of the three forms of forwarding guidance–qualitative, date-based, or outcome-based–is most effective. Rather,
A number of participants noted that each of [the] three forms of forwarding guidance could be effective in providing accommodation, depending on circumstances both at and away from the ELB.
Different types of forward guidance would likely be needed to address varying economic conditions.
Second, participants saw a danger of an adverse feedback response with respect to these policies and highlighted the importance of communication in mitigating this response.
Several participants emphasized that to guard against the possibility of adverse feedback loops in which forward guidance is interpreted by the public as a sign of a sharply deteriorating economic outlook, thus leading households and businesses to become even more cautious in their spending decisions, the Committee would need to clearly communicate how its announced policy could help promote better economic outcomes.
I thought the Committee had already addressed these concerns, so I was surprised the Committee thought this was still a challenge. Still, I recognize that this has sometimes been raised as an issue outside the Committee.
Third, in the future, unconventional policies might be less effective than they were when used following the financial crisis.
Going forward, such policies might not be as effective because longer-term interest rates would likely be much lower at the onset of a future asset purchase program than they were before the financial crisis.
The decline in real rates has reduced the effectiveness of traditional monetary policy in downturns, and the same applies to unconventional monetary policy. While the staff and participants mentioned this in relation to asset purchases, it would seem to apply to forward guidance and is an important cautionary observation that has not received much attention.
Some participants raised the concern that the scope to reduce the federal funds rate to provide support to economic activity in future recessions could be reduced further if inflation shortfalls continued and led to a decline in inflation expectations.
The importance of keeping inflation expectations anchored at the policy objective during recessions has been a recurring theme in the framework review.
I was particularly focused on the discussion of forwarding guidance, as I expect one of the outcomes of the review–and perhaps the principal one–will be an effort to make forward guidance more effective. Doing so would enhance/formalize a tool that has already been used and therefore would likely satisfy the requirement that revisions be evolutionary.
Forward guidance options: Forward guidance came in three forms after the financial crisis: qualitative, date-based, and outcome-based. These have been implemented in a sequence that I interpret as an increasing order of power. The initial form, qualitative guidance, is a language that provides a “nonspecific” indication of the duration that the fund’s rate is likely to remain at the zero lower bound. Next, the Committee turned to date- or calendar-based forward guidance. That provided a specific date before which accommodation maximum accommodation would not be removed. Last, the Committee turned to threshold-based guidance that identified the macroeconomic conditions that might allow a reduced degree of accommodation.
While the discussion was mostly about the costs and benefits of each form, there was more discussion about outcome-based guidance than there was about qualitative or date-based guidance.
Relative to qualitative or date-based forward guidance, outcome-based forward guidance has the advantage of creating an explicit link between future monetary policy actions and macroeconomic conditions, thereby helping to support economic stabilization efforts and foster transparency and accountability.
I think this understates the advantages of outcome-based guidance.
▪ In principle, outcome-based guidance only has to be announced once, front-loading the benefits of this option compared to both qualitative and date-based options, which experience suggests may be revised, perhaps again and again.
▪ Outcome-based guidance is dramatically more informative than the qualitative guidance that was intentionally vague and flexible. Date-based was clear. However, it appeared to represent at a given moment in time the Committee’s best judgment of the earliest possible date that policy might leave the zero lower bound, based on the fact that it had to be updated as the Committee extended the period over which it believed it would likely be appropriate to be at the zero lower bound.
▪ Perhaps the greatest advantage of outcome-based guidance is that the stimulus associated with it would automatically vary with economic conditions. For example, if economic conditions deteriorate, the threshold associated with this guidance would become more difficult to attain, signaling that policy would likely remain at the zero lower bound longer. Or, if the fund’s rate was above zero, the guidance would signal that the rate path would be lower than otherwise.
However, participants saw a disadvantage to outcome-based guidance.
Outcome-based forward guidance could be complex and difficult to explain and, hence, could potentially be less effective than qualitative or date-based forward guidance if those hurdles could not be overcome.
I found this unconvincing. True, qualitative guidance was not complex, but at the expense of not being very informative, since it was so vague and elastic, reflected in the fact that the implicit date kept changing. Date-based guidance was clear, though it provided guidance principally about the minimum period at zero, rather than a judgment about how long the fund’s rate was expected to remain at the zero bound. The dots provided more information about this!
I should mention that all the guidance we have been talking about was conditional (not a promise or commitment), which lowers their effectiveness.
Large-Scale Asset Purchase Programs
With respect to LSAPs, two forms were employed, which we’ll refer to as “stock” and “flow” forms. The stock form involved an announcement of a fixed cumulative size. Flow-based purchases involved communicating a specific pace that would continue until certain economic criteria are satisfied. It has the advantage that it could be communicated in terms of the concept of a policy rule, mirroring the concept of a policy rule for rates.
Participants noted that asset purchases were implemented conservatively at first because of concerns about the potential costs.
The staff’s review of the historical experience suggested that the benefits of large-scale asset purchase programs were significant and that many of the potential costs of such programs identified at the time either did not materialize or materialized to a smaller degree than initially feared.
This suggests the Committee would be willing to turn to these policies earlier and more aggressively than in the earlier experience. However, while I am not surprised that this wasn’t mentioned at this point, I expect there would be more resistance to LSAPs starting from a balance sheet at $4 trillion compared to starting below $1 trillion. This is not an “economic” argument, but my sense of the “feeling” of the Committee, perhaps because of possible political backlash.
An Inflation Threshold for Outcome-Based Forward Guidance
While the discussion was principally about the costs and benefits of unconventional policies implemented, the most interesting discussion was the brief mention of innovations.
There was one revision in forwarding guidance that was voiced, and one I found quite compelling, although it was attributed to just a few participants.
A few participants commented that outcome-based forward guidance, tied to inflation outcomes, could be a useful tool to reinforce the Committee’s commitment to its symmetric 2 percent objective.
I believe this understates the power of an inflation threshold. It does not just reinforce the commitment to the 2% objective. First, unlike qualitative and date-based guidance, such guidance could more likely be announced once and, in effect, be a commitment. For example, consider the FOMC said that the Committee would remain at zero until inflation reached 2% on a sustainable basis, a direction that the previous Chair suggested and I have talked about. That would be very powerful, though admittedly the fund’s rate might still be at zero under this commitment! It also would prevent any consideration of how low the unemployment rate fell during the period. On the other hand, it would likely be effective in keeping inflation expectations better anchored!
Second, it would automatically signal that rates will remain lower for longer if inflation underperforms relative to expectations. Very powerful, especially given how hard it has been to raise inflation.
Third, it would also virtually guarantee an overshoot of the inflation objective, consistent with a makeup policy.
New Tools (for the Fed)
Participants discussed three tools that the Fed did not use during the period of unconventional policies, though each has been used before, earlier in the U.S. experience, or in other countries.
Capping Interest Rates
The Fed has two options with respect to influencing rates using its balance sheet: It can set the quantity (size of the balance sheet) and take the price (the long-term interest rates) that results, or it can set the price and accept the quantity that results. With LSAPs, the FOMC set the quantity and the markets determined the price. Interestingly,
A few participants saw benefits to capping longer-term interest rates.
Bernanke actually suggesting capping the price rather than setting the quantity in his classic paper, which is something the FOMC did during the 1940s.1 Today, capping long-term rates is referred to as “yield curve control,” the name that the BOJ uses for this approach.
The concern with capping long-term rates is that to defend the cap, the Fed might have to do very large asset purchases and possibly lose control of the size of the balance sheet. However, it was noted, interestingly, that
Capping longer-maturity interest rates using balance sheet tools, if judged as credible by market participants, might require a smaller amount of asset purchases to provide a similar amount of accommodation as a quantity-based program purchasing longer-maturity securities.
The most interesting part of the discussion of capping rates at the October meeting was that the focus was on capping shorter-term rates rather than longer-term rates.
A majority of participants saw greater benefits in using balance sheet tools to cap shorter-term interest rates and reinforce forward guidance about the near-term path of the policy rate.
1 Remark by Governor Ben S. Bernanke Before the National Economists Club, Washington, D.C., November 21, 2002, Deflation: Making Sure “It” Doesn’t Happen Here.
Interestingly, that is what Bernanke was talking about in his classic paper. He suggested that the FOMC could begin by capping yields on “say, bonds maturing within the next two years.” If that was not sufficient, he noted that the Fed could attempt to cap yields at still-longer maturities, say, three to six years.
Participants noted that that is a way for balance sheet and forward guidance to reinforce each other. The fact that a “majority” of participants favored this, at least relative to capping longer-term rates, suggests we should put this higher on the list of possible revisions to tools in the FOMC’s toolkit.
Negative interest rates
For me, the most surprising discussion at the meeting was about negative interest rates. Individual policymakers came out against negative rates at the very outset of the review and it seemed as though negative interest rates were off the table. Apparently not. The discussion of negative rates began with the usual cautionary comments.
All participants judged that negative interest rates currently did not appear to be an attractive monetary policy tool in the United States
There was limited scope for doing so, the evidence on the effectiveness was limited, and there was concern about adverse effects on the willingness of financial intermediaries to lend and on the behavior of households and businesses. That seemed to reinforce why it was off the table. Then the surprise:
Notwithstanding these considerations, participants did not rule out the possibility that circumstances could arise in which it might be appropriate to reassess the potential role of negative interest rates as a policy tool.
I don’t recall any participant having such a favorable attitude toward negative rates. But this sentiment was attributed not to just a couple, a few, a number, or several participants, but to “participants,” suggesting that it might possibly reflect a widespread view within the Committee. Stay tuned for further discussion of this option!
A program to facilitate lending
The [staff] briefing also discussed lending programs that could facilitate the flow of credit to households or businesses.
This is a direction–funding for lending–pursued by the Bank of England’s Monetary Policy Committee alongside the U.K. Treasury, but I doubt it would receive much consideration from the FOMC. Perhaps participants didn’t want to leave out any potential options. Perhaps they were successful!
Going Forward The Committee is in no rush to come to an agreement about revisions to strategy or tools and, importantly, about substantive revisions to the “Statement on Longer-Run Goals and Monetary Policy Strategy.” It would “take some time” and the process would be “deliberate and patient.” A number of participants judged that the review could be completed around the middle of 2020. Note that only a “number” appeared confident of that! What does that suggest?