In the Nation's Interest

Can We Count on Monetary Policy?

It is very difficult to know what to think of U.S. monetary policy right now. The latest meeting of the Federal Open Market Committee (FOMC) produced a formal statement and a press conference by Federal Reserve Chairman Janet Yellen that did little to clarify either the likely policy over the next year and the Fed’s own views of basic monetary issues.

There is an inevitable tradeoff between the desire to provide forward guidance that markets can count on and the need to preserve enough flexibility to deal with unexpected developments. During Alan Greenspan’s chairmanship this tradeoff was resolved largely in favor of flexibility, largely through the strategy of avoiding any clear statements about either current or future policy. Under Chairman Bernanke, the Fed has thankfully moved toward greater openness, including a willingness to engage in a dialogue with the public and issue forward guidance about future policy. But this has not removed the fundamental tradeoff and, since the Fed is unwilling to adhere to a more rule-based policy such as targeting nominal incomes (where the Fed targets the long-term rate of income growth rather than short-term interest rates) or a hard-and-fast rule (like the Taylor rule, which bases interest rates on a formula involving the departure of inflation and employment from their desired levels), its ability to give long-term guidance is severely limited. This is a problem to the extent that uncertainty about the Fed’s ultimate outlook on inflation and growth deters companies from making long-term investments in the future.

To date, forward guidance has served mainly as a means to reassure the markets that the Fed is not likely to do anything dumb or sudden. That in itself is helpful. At a time when unemployment rates were very high and inflation negligible, few expected the Fed to raise interest rates. But it was reassuring to have the institution’s promise not to do so. Similarly, once the Fed had committed to a long-term policy of quantitative easing, it was constructive to have a statement to the effect that they would not stop mid-stream. In this light, the traditional statement of the past few years that the Fed would keep interest rates low “for a considerable time” reaffirmed a market expectation that almost surely would have existed in the absence of a statement.

But the important policy questions on which markets really move involve more fundamental issues. For instance, to what extent does the Fed view deflation as a danger, especially when low inflation is driven by oil prices, a component the Fed regularly discounts when energy is rising? What did the Fed hope to accomplish in the latest round of quantitative easing and why did it think those goals outweighed the growing burden on its balance sheet? Has monetary easing pushed stock or property prices above their equilibrium values? If so, why is this a good thing? Finally, to what extent is the Fed willing to risk higher future inflation in order to keep growth going? On these and other questions, there is far less transparency.

Recent events show this. Going into the FOMC’s most recent meeting, there was little sign that the markets expected an increase in either inflation or interest rates over the next several months. Speculation instead centered on the rather esoteric expectation that the Fed would remove language promising to keep interest rates low “for a considerable time,” which most commentators believed would signal that the time was nearing for a rate hike.

Instead, the FOMC added a sentence indicating that they can be “patient” in beginning to “normalize” the stance of monetary policy, a stance it stated was consistent with the earlier phrase. To most observers this would probably indicate that the FOMC would like to dampen market expectations of a rate hike. The Committee also retained the statement that:

[If] incoming information indicates faster progress toward the Committee's employment and inflation objectives than the Committee now expects, then increases in the target range for the federal funds rate are likely to occur sooner than currently anticipated. Conversely, if progress proves slower than expected, then increases in the target range are likely to occur later than currently anticipated.

It is unclear what message this is intended to send, other than the common sense statement that the Committee will continue to take new information into account when making its decisions. At a press conference following the statement’s release Chairman Yellen indicated in an indirect way that no rate increase would occur until at least March.

The reason why the Committee remains unable to provide clearer guidance despite an apparent desire to do so is that its members remain divided about the near-term outlook for the economy and perhaps the appropriate response to any scenario. Their forecasts of short-term interest rates at the end of next year range from no change to almost 2 percent. Given this lack of consensus, and the failure to follow a more rule-based approach, the markets will continue to guess at future Fed policy based on its view of both future economic developments and how the Fed will react to them. Although it probably does not give markets great confidence about the future, the consequences may be minimal so long as investors have faith in the FOMC’s ability and determination to keep long-term inflation low. But if this confidence ever wavered, inflation, which is clearly not a danger now, could suddenly become one.

Joseph Kennedy is President of Kennedy Research, LLC, which consults on a wide variety of policy issues. He is also a Senior Fellow at the Information Technology and Innovation Foundation.

Guest blogs are the views of the individual and not the official policy of CED.

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