In August 2011, members of the Federal Reserve’s Federal Open Market Committee (FOMC) reaffirmed their policy stance of maintaining the federal funds rate in a narrow range slightly above zero. But in an unprecedented step, they also added new language to their public release asserting that their current expectations of macroeconomic conditions would warrant “exceptionally low levels for the federal funds rate at least through mid-2013.” This new policy statement led to an unusual split of the committee – three (out of ten) voting members dissented.
What did the committee's new language mean?
There are at least two possible interpretations of this new language.
- The first is that it represents yet another move toward increased transparency.
It is the Federal Reserve revealing, in addition to its current policy decisions and justifications thereof, additional guidance about the likely path of future policy (“increased transparency” interpretation). The motivation for this increased transparency is to reduce uncertainty in the private sector about future policy actions and reduce the volatility of financial prices.
Given that the August meeting was preceded by Congressional debt-ceiling brinksmanship, S&P’s downgrade of U.S. government debt, and the associated rise in financial volatility, FOMC members may have felt that this was a good time to pursue a new approach to stabilising financial markets, namely reducing uncertainty about the future path of short-term interest rates. Under this interpretation, the new language was not indicative of a change in policy but rather was primarily an attempt to dispel uncertainty.
Paul Krugman summarised this view dismissively in a blog post titled “The Fed states the obvious” in which he claimed “The Fed didn’t announce a new policy. And despite what some press reports said, it didn’t even commit to keeping rates low; all it did was say that if the economy stays weak, rates will stay low — well, duh” (Krugman 2011).
- The second interpretation is that the new language reflects a significant change in policy by the committee.
This would be consistent with theoretical work on optimal monetary policy in the face of the zero-bound (“policy change” interpretation). Many economic models imply that, even though the zero bound on interest rates may be a binding constraint on monetary policymakers, optimal policy could still alleviate many of these effects by committing to holding interest rates low for a significant period even after the zero-bound episode is no longer binding. This promise to hold interest rates low for extended period should raise inflationary expectations and thereby lower real interest rates, which in turn should help stimulate consumption and investment during the period of the zero bound. Such a policy was advocated by none other than Ben Bernanke in 2000 during the depths of Japan’s lost decade.
Furthermore, while the benefits of such a strategy derive from raising inflationary expectations, they do not require the central bank to publicise this component of the policy. This stands in sharp contrast to another policy action, namely raising the Fed’s inflation target, which has been advocated by, among others, Krugman, Ken Rogoff, Greg Mankiw and Olivier Blanchard, but which has also been explicitly and publicly rejected by Chairman Bernanke and several other members of the FOMC. Given the recent public focus on the Federal Reserve, particularly increasingly combative Congressional oversight, it should come as no surprise to see Federal Reserve officials be leery of any actions that directly call into question their commitment to price stability. As a result, the Fed’s statement about holding interest rates low for a two-year period may have seemed like the least controversial way to move toward what some economic models characterise as the optimal policy response in the face of the zero lower bound.
Commentators following this "policy change" interpretation had mixed reactions. For example, a blog post from Macroeconomic Advisers interpreted the FOMC’s statement as “start[ing] easing through communication” and approvingly termed it “unprecedented and very effective” (Macroeconomic Advisers 2011). Stephen Williamson (2011), on the other, argued that the disclosure of the anticipated path of future policy rates actually increased uncertainty:
“In the case of last week's FOMC decision, there was certainly no statement that the FOMC was thinking about the world in a different way. Thus, presumably the decision rule has not changed. If that is true, than the FOMC's decisions should be consistent with what it has been doing. But Kocherlakota argues that is not the case, and I think he is right. A decision that may appear to make the Fed's behavior more predictable actually makes it less so. Instead of asking why the dissenters on the FOMC voted the way they did, we should be asking why the other people on the committee voted the way they did. And we should not have to ask that. We are now more confused, and that is not good."
This view follows from Kocherlota’s interpretation of the FOMC decision as “designed to let the public know that the fed funds rate is likely to stay between 0 and 25 basis points over the next two years, not just over the next three to six months. Hence, the new language is intended to provide more monetary accommodation than before" (Kocherlakota 2011).
When should we have expected the Fed to start raising interest rates?
The policy change explanation implies that the Federal Reserve’s statement about future policy rates represents a deviation from the policy path that one would have expected otherwise. Is there any evidence that the federal funds rate would likely have risen before mid-2013? To address this question, we apply a methodology similar to Taylor (1993) and Orphanides (2003) by characterising the central bank’s interest-rate response to current and expected future macroeconomic conditions via a response function based on inflation, the growth rate of real GDP, and the output gap. We use expectations that correspond to the expectations of the Federal Reserve formed prior to FOMC meetings for each macroeconomic variable. The rule allows for policy inertia via a response to lagged levels of the interest rate.
As a first step, we estimate the parameters of the Fed’s response function using the Greenbook forecasts prepared prior to each FOMC meeting using data from 1982Q3 until 2005Q4. The end date is determined by the fact that the Federal Reserve releases past Greenbook forecasts only with a 5-year lag. More details on estimating Taylor rules of this form are provided in Coibion and Gorodnichenko (2011). The estimated coefficients allow us to characterise the “typical” response of the Federal Reserve to its expectations of both current and future economic conditions. Note that while the rule only includes three macroeconomic variables, this does not in any way imply that the Fed only looks at these variables. Rather, the rule assumes other relevant information (such as from financial market conditions) are incorporated into the Fed’s forecasts of future macroeconomic conditions.
While Greenbook forecasts are not available since 2005, we can use forecasts of future output and inflation from professional forecasters instead to predict the path of future interest rates under the assumption that the Federal Reserve follows the same reaction function since 2006 as it had before. The results are presented in Figure 1. Note that the predicted federal funds rate tracks the actual federal funds rate closely until the end of 2008. Once the FOMC announced a target range for the federal funds rate of 0 to 25 basis points in December of 2008, the predicted interest rate falls sharply below zero, illustrating the severity of the zero-bound constraint. However, since early 2009, the predicted interest rate has been gradually rising back toward zero. Given current economic forecasts, our estimated reaction function of the Fed predicts that interest rates should become positive starting in mid to late 2012, but nonetheless remain within the current target range of less than 25 basis points until the end of 2013.
Figure 1. Predicted federal funds rates
Given current economic forecasts for 2012-2013, the Fed’s indication that policy rates are likely to remain around zero until at least mid-2013 appears consistent with the historical behaviour of the Federal Reserve. The announced path of policy rates is remarkably close to the projected path (subject to the zero constraint), where the projection is based on what the Fed did in the past, so little evidence exists that the new language should be interpreted as a direct change in policy (beyond possible movement toward increased transparency) or that the Fed has altered the relative weight assigned to inflation and output stabilisation in its objective function. Instead, our results suggest that, contrary to those who condemn the Federal Reserve for becoming increasingly “dovish”, the FOMC’s projected policy path is well aligned with its historical behaviour and current projections of future macroeconomic activity.
Bernanke, Ben S. (2000), “Japanese Monetary Policy: A Case of Self-Induced Paralysis?” in Ryoichi Mikitani and Adam S. Posen (eds.), Japan’s Financial Crisis and its Parallels to U.S. Experience, Special Report 13 (September 2000), Washington, DC: Institute for International Economics.
Coibion, Olivier and Yuriy Gorodnichenko (2011), “Why are target interest rate changes so persistent?” NBER Working Paper 16707.
Kocherlakota, Narayana (2011), "Statement by Narayana Kocherlakota on Dissenting Vote at August 9, 2011, Meeting of the Federal Open Market Committee", August 12.
Krugman, Paul R. (2011), "The Fed States the Obvious", 9 August.
Macroeconomic Advisers (2011), "FOMC Statement Comment: Unprecedented and Very Effective", 11 August.
Orphanides, Athanasios (2003), “Historical Monetary Policy Analysis and the Taylor Rule,” Journal of Monetary Economics 50(5), 983-1022.
Taylor, John B. (2003), “Discretion versus policy rules in practice,” Carnegie-Rochester Conference Series on Public Policy 39, 195-214.
Williamson, Stephen (2011), "Commitment, the State of the World, and Dissent", 15 August.