The U.S. Federal Reserve faces a daunting task as it moves away from near-zero interest rates: communicating its plans without unduly shaking up financial markets. The job would be easier if everyone involved recognized that the central bank’s actions must depend on the state of the economy, not on the calendar.
Consider what happened in July 2015, when Chair Janet Yellen gave a policy speech in Cleveland. Out of almost 3,800 words on various subjects, the financial media focused on the following: “Based on my outlook, I expect that it will be appropriate at some point later this year to take the first step to raise the federal funds rate and thus begin normalizing monetary policy.” Although Yellen specified that any move would depend on the data, the headlines cried out: The federal funds rate will finally leave the zero lower bound by the end of 2015.
Investors came to expect action sooner rather than later. As a result, when global financial turmoil prompted the Fed to hold off at its September policymaking meeting, markets were surprised. The yield on the 2-year U.S. Treasury note moved more than on any other meeting date since 2009, and a survey of primary dealers -- financial institutions that trade directly with the Fed -- gave the central bank one of the lowest scores on communication effectiveness since 2011.
The events of 2015 demonstrate both the power and danger of time-based forward guidance, in which central banks tie their interest-rate predictions to specific dates, rather than to the evolution of macroeconomic conditions such as inflation and unemployment. It’s an area where subtlety has proven extremely difficult: Although Fed officials always qualify time-based guidance by noting that incoming data could change their outlook, much of the media -- and many in the markets -- routinely ignore the qualifications. It’s as if they were addicted to thinking about monetary policy in calendar terms alone.
In a report written with Michael Feroli of JP Morgan Chase, David Greenlaw of Morgan Stanley and Peter Hooper of Deutsche Bank, we argue that the routine use of time-based forward guidance has two major disadvantages. First, it reduces the sensitivity of interest rates to macroeconomic news -- exactly the opposite of what good communication by a central bank should accomplish. The Fed should want markets to do a lot of its heavy lifting. If, for example, the unemployment rate rises unexpectedly, markets should drive down interest rates on the expectation that the Fed will lower them at its future policy-making meetings. But if markets believe that the Fed has already committed to a certain interest-rate path, they might ignore the unemployment data, leaving interest rates higher than where the Fed would want them to be.
Second, time-based forward guidance limits the Fed’s options. If the central bank commits to raising rates (or is perceived to have done so) and then negative macroeconomic news comes along, officials face a dilemma: Raise rates anyway, or abandon the commitment and lose credibility. The Fed’s September 2013 and September 2015 decisions to maintain stimulus, for example, were both preceded by time-based forward guidance and unexpected bad news about the economy. Primary dealers gave both meetings very low communication scores, reflecting the belief that the Fed had broken a promise to tighten -- even though the Fed likely believed that no such promise had been made.
To be sure, time-based forward guidance has its place. For example, when the central bank’s short-term interest rate target has reached zero and can’t be lowered further, promising to keep it low -- as the Fed did in August 2011 -- can provide added stimulus by affecting longer-term interest rates. But as the Fed lifts off from the zero lower bound, focusing on dates becomes counterproductive. The discussion should turn instead to the circumstances under which the Fed will act.
Policymakers, the financial media, and market participants all bear some responsibility. If they want to avoid unpleasant surprises and do what’s best for the economy, they must wean themselves from their addiction to the calendar.
By Frederic S. Mishkin & Amir Sufi
Frederic S. Mishkin is a professor at Columbia University‘s Graduate School of Business, and a former governor of the Federal Reserve System. Amir Sufi is a professor at the University of Chicago’s Booth School of Business. -- Ed.