Is the « forward guidance » strategy credible in ensuring greater transparency in US monetary policy?

The ineffective interest-rate channel

The deflationary risk of a « zero » interest rate policy renders the main transmission channel for monetary policy ineffective. As a result, communication proves to be the main factor capable of influencing the behavior of private agents. In 2003 and 2004 in the United States, the key interest rate was 1%. Logic dictated that interest rates on long-term bonds should rise in anticipation of an increase in the key interest rate. On the contrary, the 10-year rate continued to fall, characterizing a « conundrum » phenomenon.

This episode is a good example of the disconnection between future expectations of the key interest rate by the private sector and the strategy of central bankers. Communication replaces the interest rate channel to compensate for this disconnect.

Tools to ensure monetary policy transparency

There are three possible ways of ensuring transparent communication. The first is the use of « code words » at press conferences, capable of implicitly revealing the expectations of economic activity formulated by the members of the monetary policy decision-making committee. This communication tool suffers from a lack of quantitative arguments capable of making the outlook for the real economy more explicit.

The second way is therefore to draw up a quantitative report on economic forecasts that would justify the future trajectory of interest rates and real activity. A first condition of effectiveness for this second means is to allow for a margin of error in its macroeconomic trajectories, by avoiding announcing target values and publishing a range of estimates.

Finally, a second condition is to propose alternative scenarios to the central scenario to guide the expectations of private agents. However, even if these two conditions were met, the forecasts would not be sufficient to inform the policy intentions of the decision-makers on the monetary policy committee.

Finally, a third means of communication becomes necessary: « forward guidance » or the explicit commitment to a maximum interest rate level, irrespective of the anticipated margin of error in economic forecasts. This third means not only makes the central bank’s strategy explicit, but above all reinforces its credibility, and hence the effectiveness of the channels through which monetary policy is transmitted.

Greater transparency since 2008

The arrival of Ben Bernanke as Chairman of the US Federal Reserve in 2006 was a source of significant change. Since 2008, the « Summary economic projections » have ensured greater transparency in the decisions of the FOMC, the Federal Open Market Committee responsible for defining the direction of US monetary policy. Above all, the forecasts included are established over a three-year period, which justifies the extension of the « forward guidance » policy until mid-2015.

However, these reports do not provide any information on alternative scenarios that could replace the one defined by the committee. The report therefore only makes it possible to know which projection has been chosen from a set of discussed trajectories, but does not define a set of possible trajectories depending on the economic trend.

This lack of transparency can, however, be justified. By specifying the quantitative methods used, and hence the confidence interval characterizing the probability of achieving the economic forecast announced, the committee makes explicit the assumptions of the forecasting model. These assumptions may be parameterized according to the committee’s target objectives, or they may be defined on the basis of a desired monetary policy. These two possibilities are extreme cases, and do not characterize central banking. But these risks and this total transparency of information are not always desirable.

The first argument concerns the transparency of the forecasting models used, which make the target levels of economic factors public. Announcing a desire to achieve an excessively high level of price rises or a target unemployment rate can be a source of political instability likely to affect the economic cycle and therefore the effect of the monetary policy decided on the basis of the macroeconomic forecasts derived from the model.

A second argument is based on the effectiveness and credibility of economic transparency. The main difficulty with a transparent communication policy is to understand how expectations are formed in the private sphere. For example, if expected future inflation is the result of a consensus average established over a long period, then transparency is less useful, since communicating more will tend to deviate these expectations, thus making it more vulnerable to changes in economic conditions.

On the other hand, if the consensus takes account of the slightest financial or economic shock, then transparency will help reduce over-reaction to economic conditions on the part of the private sector. It is precisely in this second scenario that the FED finds itself: uncertainties about a medium-term recovery in the US economy are affecting these expectations, and transparency is becoming a necessity.

Conclusion

The credibility of forward guidance lies in its ability to improve the transparency of US monetary policy. The current rate levels set by the Fed should normally encourage expectations of an interest rate rise. However, thanks to the forward guidance strategy, these expectations can only be affected by the current level of interest rates from mid-2015 onwards. The FOMC therefore opts for transparency in its decision-making and operating procedures, which helps to maintain its ability to stabilize the economy despite the inefficiency of the interest rate channel.

References

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