Frederic S Mishkin: Whither Federal Reserve communications
Speech by Mr Frederic S Mishkin, Member of the Board of Governors of the US Federal
Reserve System, at the Peterson Institute for International Economics, Washington, DC,
28 July 2008.
The original speech, with a full list of references, can be found on the US Federal Reserve System's website
(www.federalreserve.gov).
* * *
Over the years, the Federal Reserve has significantly increased the transparency of
monetary policy making. For example, starting in 1979, the Federal Open Market Committee
(FOMC) has included economic projections of the FOMC participants in each semiannual
Monetary Report to Congress
Since 1994, the FOMC has publicly announced changes in its
target for its policy instrument, the federal funds rate. Most recently, the FOMC extended the
horizon for its projections in October 2007 and is now publishing these projections four times
a year.1
Has the Federal Reserve gone far enough? Or would further advances in transparency be
useful? I will argue here that the science of monetary policy suggests that the Federal
Reserve can indeed go further in enhancing its communication strategy, and that doing so
would produce important benefits in economic performance and democratic accountability. I
will also outline a specific proposal of my own and address a few concerns that some might
have with elements of this proposal.
Before proceeding, I would like to emphasize that my remarks today reflect only my own
views and not necessarily those of anyone else on the Board of Governors or the FOMC.
Indeed, this disclaimer has even more meaning now since, as many of you know, I will be
leaving the Federal Reserve Board at the end of August and returning to Columbia
University.2
What are the key scientific principles for monetary policy communication?
To think about what kind of central bank communication is desirable, let's begin by
considering some key scientific principles regarding the objectives of monetary policy and the
benefits of central bank transparency.
Objectives of monetary policy
The modern science of monetary policy is based on the idea that the central bank's objective
is to maximize the economic well-being of the households in the economy (Mishkin 2007d).
Broadly speaking, this objective can be expressed in terms of two components: minimizing
the deviations of inflation from its optimal rate and minimizing the deviations of real economic
activity from its so-called natural rate, which is the efficient level determined by the
productive potential of the economy. Moreover, this analytical formulation of the objectives of
monetary policy captures the essential mission of the Federal Reserve System, as
summarized by the Federal Reserve's dual mandate to promote price stability and maximum
employment.3 By the way, I believe that the Federal Reserve's role as the lender of last
resort is also crucial for fostering the stability of the financial system, but I will not elaborate
further on that today.4
Policymakers, academic economists, and the general public broadly agree that maintaining a
low and stable inflation rate significantly benefits the economy. For example, low and
predictable inflation simplifies the savings and retirement planning of households, facilitates
firms' production and investment decisions, and minimizes distortions that arise because the
tax system is not completely indexed to inflation. Moreover, I interpret the available economic
theory and empirical evidence as indicating that a long-run average inflation rate of about 2
percent, or perhaps a bit lower, is low enough to facilitate the everyday decisions of
households and businesses while also alleviating the risk of debt deflation and other pitfalls
of excessively low inflation.5
The rationale for promoting maximum sustainable employment is also fairly obvious:
Recessions weaken household income and business production, and unemployment hurts
workers and their families. As I have outlined elsewhere, these two objectives are typically
complementary and mutually reinforcing: that is, done properly, stabilizing inflation
contributes to stabilizing economic activity around its sustainable level, and vice versa.6
Nevertheless, it's important to note a fundamental difference between the objectives of price
stability and maximum sustainable employment. On the one hand, the long-run average rate
of inflation is solely determined by the actions of the Federal Reserve.7 On the other hand,
the level of maximum sustainable employment is not something that can be chosen by the
Federal Reserve, because no central bank can control the level of real economic activity or
employment over the longer run.8 In fact, any attempt to use stimulative monetary policy to
maintain employment above its long-run sustainable level would inevitably lead to an upward
spiral of inflation with severe adverse consequences for household income and employment.
Recent research has also emphasized the challenges of making contemporaneous
"realtime" assessments of the level of maximum sustainable employment, because this level
cannot be directly observed and can be inferred only with considerable uncertainty. Thus, in
making these assessments, monetary policy makers need to draw on a wide range of
indicators from labor, product, and financial markets.9
Benefits of central bank communication
A central element in successful monetary policy is the establishment of a nominal anchor.
Why is this so important? The expectations for inflation of households and firms are a key
factor in determining the actual behavior of inflation.10 In the absence of a firm nominal
anchor, these expectations may wander as the private sector revises its assessment of the
rate at which inflation is likely to settle, and those movements in expectations for future
inflation can generate pressure on the current inflation rate.
By establishing a transparent and credible commitment to a specific numerical inflation
objective, monetary policy can provide a firm anchor for long-run inflation expectations,
thereby directly contributing to the objective of low and stable inflation.11 Additionally, the
presence of a firm nominal anchor gives the central bank greater flexibility to respond
decisively to adverse demand shocks. Such a commitment helps ensure that an aggressive
policy easing is not misinterpreted as signaling a shift in the central bank's inflation objective
and thereby minimizes the possibility that inflation expectations could move upward and lead
to a rise in actual inflation. A strong nominal anchor can be especially valuable in periods of
financial market stress, as we have been experiencing recently, when prompt and decisive
policy action may be required to minimize the risk of a severe contraction in economic activity
that could exacerbate uncertainty and financial market stress.12 Thus, the establishment of
an explicit numerical inflation objective can play an important role in promoting financial
stability as well as the stability of employment and inflation.
More broadly, it should be noted that central bank transparency contributes importantly to
democratic accountability and economic prosperity.13 In particular, in a democratic society,
the central bank has a responsibility to provide the public and its elected representatives with
a full and compelling rationale for monetary policy decisions. Clarification of the central
bank's objectives and policy strategies also reduces economic and financial uncertainty and
thereby facilitates efficient decisionmaking by households, businesses, and financial market
participants.
How has Federal Reserve communication been enhanced?
The Federal Reserve has been a pioneer in a number of aspects of central bank
communication, many of which I have mentioned at the beginning of these remarks. Now I
would like to discuss some of the main aspects of the enhancements to the FOMC's
communication strategy that were announced in November. First, the forecast horizon for the
FOMC's economic projections now covers three calendar years instead of only two years.
For example, the projections released after the past meeting extend to 2010. Second, the
Committee now publishes these projections four times a year rather than twice a year. Third,
the projections now include a forecast of overall consumer price inflation, as measured by
the price index for personal consumption expenditures (PCE), a broad price index that
corresponds closely to the price stability objective in the Federal Reserve's dual mandate.
These forecasts of overall inflation complement the ongoing forecasts the Committee
provides of the so-called core version of the PCE price index, which excludes the prices of
food and energy.14 Fourth, the release of the projections now includes a narrative describing
FOMC participants' views of the principal forces shaping the outlook and the sources of risks
to that outlook.
As I indicated last November, I believe that these enhancements provide important
information that will contribute to the public's understanding of our objectives and the
rationale for our policy actions and hence will facilitate the decisionmaking of households and
businesses.15
As reported last week in conjunction with the minutes of the latest FOMC meeting, the
projections for overall PCE inflation at a three-year horizon (which is currently 2010) fell in a
range of 1.6 percent to 2.1 percent, and the central tendency of these projections was 1.8
percent to 2 percent.16 Each FOMC participant's projection is made under the assumption of
"appropriate" monetary policy--that is, the path of policy calibrated to achieve outcomes for
economic activity and inflation that are, in the eyes of each participant, most consistent with
the objectives of price stability and maximum employment. For that reason, the longer-run
inflation projections provide information about each FOMC participant's assessment of the
long-run inflation rate that best promotes those dual objectives--what I have referred to as
the "mandate-consistent inflation rate."17 The increased information that these projections
convey regarding FOMC participants' views of the mandate-consistent inflation rate,
combined with the FOMC's continuing commitment to keeping inflation low and stable,
should help anchor inflation expectations and actual inflation more firmly.
The longer-run projections of output growth and unemployment are heavily influenced by
FOMC participants' assessments of the sustainable rates of output growth and employment.
As a result, these projections can provide the public with useful information regarding the
FOMC's estimates of the sustainable rate of output growth (often referred to as potential
output growth) and of the sustainable unemployment rate (often referred to as the natural
rate of unemployment).
Providing projections for the short run as well as for the longer run encourages FOMC
participants to think in terms of desirable paths for inflation and output, a discipline that
economic research suggests will produce better policy outcomes. These projections also are
useful in enabling the FOMC to explain its policy decisions and strategies more fully in the
context of its medium-term objectives for economic activity and inflation as well as the risks
to those objectives. As a result, the public and the Congress can better assess whether our
forecasts of the economy are reasonable and whether we are pursuing a policy that is
consistent with achieving the dual mandate of price stability and maximum sustainable
employment. The result should be increased accountability that is consistent with basic
democratic principles.
Is there room for further improvement?
Although the enhancements to the FOMC's communication strategy last November have
been a major step forward, I believe that there is some room for further improvement.
Conceptual considerations
As a conceptual matter, the three-year horizon of the projections may not be long enough to
provide sufficient clarity about the views of FOMC participants regarding the
mandateconsistent inflation rate, the sustainable growth rate of output, or the natural rate of
unemployment. Moreover, these projections do not establish a transparent and credible
commitment to a specific numerical inflation objective and hence do not provide a sufficiently
firm nominal anchor.
In my view, the length of the forecast horizon is particularly relevant at the current juncture in
considering the projections for output growth and unemployment. Because of the recent
adverse shocks to the economy--including turmoil in financial markets and the sharp
increase in the prices of oil--output growth in recent quarters has fallen below potential, and
the unemployment rate is, as best as I can judge, above the natural rate. Similarly, sharp
increases in the prices of many commodities have driven inflation above rates consistent with
price stability. Even under appropriate monetary policy, Committee forecasts of inflation,
output growth, and unemployment might not settle at their respective long-run rates within
the three-year horizon, obscuring Committee participants' views about these key parameters.
This problem may currently be somewhat less acute for the current set of inflation
projections, because inflation is projected to moderate to about 2 percent or below by the
end of the projection period. Nevertheless, to the extent that some slack in economic activity
is projected to persist through 2010, that slack might well induce a modest further decline in
inflation, implying that policymakers' projections for inflation in 2010 might be a bit higher
than their assessments of the mandate-consistent inflation rate.
Empirical evidence
My discussion of room for improvement relative to the Federal Reserve's current
communication strategy has been theoretical. There is, fortunately, evidence from a number
of countries that have adopted an explicit numerical goal for inflation, including Canada, New
Zealand, Sweden, and the United Kingdom.18 And there is also evidence from the
experience of the European Central Bank (ECB), which has not adopted an explicit
numerical goal but has provided a fairly precise verbal description of its commitment to
keeping inflation "below, but close to, 2 percent in the medium term."19
18
Further details on the experiences of these countries--as well as other economies that have adopted explicit
numerical inflation objectives--may be found in Mishkin and Posen (1997), Bernanke and others (1999), and
Mishkin and Schmidt-Hebbel (2001, 2007).
19
See ECB (2003, p. 6). Indeed, the experience of other central banks confirms that establishing a specific
numerical value for the inflation objective can be viewed as a technical issue that does not necessarily require
any new legislation, but, of course, this depends on the political system in each country. In Sweden, for
example, the government announced in 1991 that low inflation was an overriding political goal, but the
Riksbank's January 1993 announcement of an explicit inflation objective did not coincide with any legislative
action (Giavazzi and Mishkin, 2006). The Riksbank stated an inflation goal accompanied by a two-year
startup period, so that the goal was to become operational in January 1995. Soon after the initial announcement by
the Riksbank, various changes to its legislative mandate were proposed. Many of these were adopted in 1999,
when a new constitution and new Riksbank Act came into effect. Similarly, the Reserve Bank of Australia
announced a numerical inflation objective in 1993, and this objective was formalized about three years later
when the government and governor issued a joint "Statement on the Conduct of Monetary Policy" (see Fraser,
1993; Reserve Bank of Australia and the Treasurer of Australia, 1996; and Reserve Bank of Australia, 2008).
And in Chile, the law establishes broad objectives for the Central Bank of Chile, but the Bank itself has
elaborated that its mandate for price stability is to be interpreted at aiming for a 3 percent inflation rate at a
two-year horizon (see Central Bank of Chile, 2007).
Over the past several years, empirical work that has drawn on this international experience
has found some significant benefits in anchoring inflation expectations by establishing an
explicit inflation objective. For example, let's take a look at three figures from a recent paper
by Beechey, Johannsen, and Levin.20 Figure 1 depicts the long-run inflation expectations
from surveys of professional forecasters in the euro area and in the United States. Inflation
expectations in both economies are relatively well anchored. The lines on the left for the euro
area are extremely flat, with only tiny and occasional deviations from the ECB's inflation goal
of keeping inflation just below 2 percent over the medium run. In the United States, inflation
expectations as measured by the mean or median forecast in the Survey of Professional
Forecasters are also quite fixed at around 2-1/2 percent for consumer price index (CPI)
inflation, but those in other surveys move around somewhat more.
However, there is substantially greater disagreement in long-run inflation forecasts for the
United States than for the euro area. As shown in figure 2, the standard deviation of U.S.
inflation forecasts at each survey date is higher than the standard deviation of corresponding
euro area inflation forecasts. Moreover, the degree of dispersion in the views of individual
forecasters has gradually declined towards negligible levels for the euro area but not for the
United States. One obvious interpretation of these patterns is that professional forecasters in
the United States are less certain about the Federal Reserve's longer-term inflation goal.
That uncertainty may also explain differences in the behavior of inflation compensation as
implied by the gap between nominal and real yields on long-term bonds. Figure 3 depicts
farforward inflation compensation (that is, the one-year-forward rate nine years ahead) for the
United States and the euro area. Inflation compensation, sometimes referred to as
"breakeven inflation," reflects not only inflation expectations but also a premium that
compensates for uncertainty about inflation outcomes at the specified horizon. Evidently,
farforward inflation compensation for the euro area displays much smaller fluctuations than for
the United States, consistent with greater stability of inflation expectations and a lower
degree of uncertainty about longer-run inflation outcomes. Moreover, regression analysis
confirms that U.S. far-ahead forward inflation compensation exhibits statistically significant
responses to surprises in macroeconomic data releases--consistent with the view that market
participants are continuously revising their views about the longer-run outlook for U.S.
inflation. In contrast, euro-area inflation compensation does not respond significantly to
economic news.21
One concern might be that these benefits in anchoring inflation expectations could come at
the expense of the performance of output growth. However, the empirical evidence suggests
that central banks with explicit inflation goals do not have worse output performances than
central banks, such as the Federal Reserve, that have not specified an explicit numerical
goal for inflation.22
In addition, the international experience suggests that an explicit inflation goal does not imply
that these central banks place more emphasis on stabilizing inflation to the detriment of
stabilizing output. Figure 4 plots the standard deviation of headline inflation (measured as the
quarter-on-quarter change at an annual rate) against the standard deviation of the
unemployment gap as estimated by the Organisation for Economic Co-operation and
Development. Note that the United States appears near the top of the graph, as the country
with the highest volatility of unemployment gaps.23 Moreover, a number of researchers have
shown that the response of policy interest rates to economic activity and inflation in the
United States and euro area is quite similar, suggesting that the Federal Reserve and the
ECB place similar weights on inflation and activity.24
This overview of the evidence should not be viewed as suggesting that the steps that the
FOMC has taken to improve its communications over the past couple of decades or the more
recent enhancements last fall have provided no benefits. Rather, this analysis supports the
view that some room for further improvement still remains.
What should be done? A proposal
In light of these considerations, I would like to suggest several specific modifications to the
Federal Reserve's current communication strategy.
•
First, the horizon for the projections on output growth, unemployment, and inflation
should be lengthened. This change might involve simply an announcement of
FOMC participants' assessment of where inflation, output growth, and
unemployment would converge under appropriate monetary policy in the long run.
Alternatively, the horizon for the projections could be extended out further, say to
five or more years.
•
Second, FOMC participants should work toward reaching a consensus on the
specific numerical value of the mandate-consistent inflation rate, and this consensus
value should be reflected in their longer-run projections for inflation.25
•
Third, the FOMC should emphasize its intention that this consensus value of the
mandate-consistent inflation rate would only be modified for sound economic
reasons, such as substantial improvements in the measurement of inflation or
marked changes in the structure of the economy.
Would this proposal work?
It is reasonable to ask a few questions about whether these proposed changes would be
feasible or desirable adjustments to the Federal Reserve's communication strategy.
Would this proposal be consistent with the dual mandate?
Some commentators have worried that establishing a specific numerical inflation objective
might lead to an overemphasis on controlling inflation and not enough concern about
stabilizing real economic activity. My proposal is, however, consistent with the dual mandate,
because it has the advantage of being less likely to be misinterpreted as a commitment to
control inflation within a tight range over short horizons, since it only involves a consensus on
the mandate-consistent inflation rate and an agreement not to change it without scientific
justification. By so doing, this proposal should enhance the ability of monetary policy to
stabilize fluctuations in economic activity, and therefore support the dual objectives provided
to the Federal Reserve by congressional legislation.
One lesson from the experiences of foreign central banks with explicit inflation objectives is
that such a goal is indeed consistent with a dual mandate for stable prices and maximum
employment. Some of the central banks that have explicit inflation objectives have mandates
that specifically include other objectives such as output stabilization and financial stability.
For example, the regulations governing the Norwegian central bank specifically state that
monetary policy should contribute to stable developments in output and employment.
Similarly, the Reserve Bank of Australia aims at encouraging strong and sustainable
economic growth while ensuring that consumer inflation is consistent with the explicit
numerical objective over the medium run.
Even at central banks where the inflation objective appears to be the primary goal,
policymakers do acknowledge that the stability of economic activity is also an important
objective. For instance, Charles Goodhart, a former member of the Bank of England's
Monetary Policy Committee (MPC), has emphasized that the MPC aims at stabilizing both
inflation and real economic activity and that its monetary policy strategy is quite similar to that
of other central banks such as the Federal Reserve.26 Moreover, as I noted earlier, the
empirical evidence is consistent with this view: Central banks with explicit inflation objectives
do not have worse outcomes for output growth and do not appear to be favoring inflation
stabilization at the expense of output stabilization.
Should the inflation objective be stated as a specific numerical value rather than a
range?
Establishing a specific numerical value for the inflation objective is a crucial aspect of my
proposal. As discussed in my recent speech with the whimsical title of "Comfort Zones,
Shmumfort Zones," publishing a range of values for the inflation objective has a number of
undesirable features.27 For example, when the price stability objective is formulated in terms
of an acceptable range of inflation outcomes, the policy implications may be difficult to
interpret and may make it harder for a committee of policymakers to decide on an
appropriate course of monetary policy.
Describing inflation objectives in terms of a comfort zone could also lead to perverse
expectations dynamics that leads to larger fluctuations in economic activity.28 Moreover, the
uncertainty associated with long-run inflation under a zone could affect the perceived
longterm real interest rates faced by households and firms through differential effects on the
expectations of different agents, a pitfall that seems particularly plausible given the
dispersion in professional forecasters' long-run expectations for U.S. inflation, as shown in
figure 2.29
Indeed, one important lesson from the international experience is that point objectives have
proven more effective than ranges in anchoring inflation expectations.30 And even in cases
where the inflation objective is formulated in terms of a band, emphasizing the midpoint of
that band helps allay concerns that the central bank will only take aggressive policy actions
at the edges of the band. In light of these considerations, many foreign central banks have
taken steps to move away from an inflation objective that is expressed as a range and have
moved toward an objective that is expressed as a single numerical value, as does my
proposal here.
For example, the Bank of England initially announced an inflation objective in terms of a
range from 1 percent to 4 percent for the Retail Price Index excluding mortgage interest
payments (RPIX), but this range was perceived as a band of indifference that implied the
Bank would be equally satisfied with inflation outcomes anywhere within the range. Perhaps
partly as a result, inflation expectations and realized inflation tended to remain close to the
top of the range. Thus, the objective subsequently was modified to a point target of 2-1/2
percent for RPIX inflation, where inflation above or below that value was viewed as being
equally undesirable. Inflation expectations converged quickly to this new rate in surveys of
both households and professional forecasters, and the move was favorably received both by
the public and by financial markets.31
27
Mishkin (2008c).
28
Mishkin (2008c).
29
At a given point in time, the yield on a bond with a specific maturity is determined by the views of the "marginal
investor" who is indifferent between buying and selling that bond. Thus, if financial market participants have
heterogenous views about the central bank's inflation objective, the identity of the marginal investor might vary
systematically over time in ways that influence the evolution of long-term bond yields. Another pitfall is that if a
central bank places a high degree of emphasis on the boundaries of a range, then these threshold effects
imply nonlinearities in the conduct of monetary policy that are likely to produce less desirable economic
outcomes; see Orphanides and Wieland (2000).
30
See Mishkin and Westelius (2008) and Mishkin (2008c).
31
In June 1995, the range of 1 percent to 4 percent was dropped and the goal became an inflation rate of 2-1/2
percent or less for RPIX inflation. The goal became a point target of 2-1/2 percent on the RPIX with deviations
BIS Review 95/2008
In another instructive example, the ECB had initially emphasized a broad objective of
keeping inflation below 2 percent over the medium term, but in May 2003, the ECB clarified
that policy would be aimed at maintaining inflation below, but close to, 2 percent. That
clarification was welcomed by market participants and likely contributed to the firm anchoring
of long-run inflation expectations.
Would this proposal be misinterpreted as establishing a goal for maximum
employment?
As I have emphasized, a central bank can determine the long-run average inflation rate but
cannot choose the maximum sustainable level of employment, which is determined by the
underlying structure of the real economy. Thus, one might worry whether providing
longerhorizon projections for output growth and employment as well as inflation might be
mistakenly interpreted as establishing specific--and ultimately infeasible--goals for real
economic activity. I do not believe this potential pitfall poses a substantial risk. Because
monetary policy determines the inflation rate in the long run, agreement on the
mandateconsistent inflation rate among FOMC members can only lower uncertainty about future
inflation. In contrast, differences in the long-run projections for output growth and
unemployment across FOMC participants are inevitable, as these factors are outside of the
Committee's control and inherently uncertain given our understanding of economic
fluctuations. The ongoing dispersion in long-run projections for output growth and
unemployment that is a feature of my proposal would help underscore that these projections
are assessments of potential output growth and the natural rate of unemployment and should
not be viewed as numerical objectives chosen by the FOMC.
Could the numerical inflation objective be modified if appropriate?
One might be concerned about whether the numerical inflation objective could be
subsequently adjusted for sound economic reasons. However, I would again draw on the
experience from other central banks and point out that changing the technical specification of
the inflation goal has been very well received elsewhere.
For example, in late 2003, the inflation target of the Bank of England was switched from a
21/2 percent target for RPIX inflation to a 2 percent target for the CPI.32 Despite some
concerns both from the public and the Bank about the change, it appears to have been
implemented with few problems. Indeed, figure 5 shows the distribution of professional
forecasters' medium- to long-range inflation projections in the United Kingdom in the fourth
quarter of 2001, the first quarter of 2004, and the second quarter of this year. These
expectations were initially clustered relatively tightly around the inflation objective of a 2-1/2
percent rate but moved to the new value of 2 percent within a few months of the announced
change and have remained firmly anchored since then, especially compared with the
dispersion in views regarding the longer-term outlook for U.S. inflation (Gürkaynak, Levin,
and Swanson, 2008). Similarly, as I mentioned earlier, the ECB also clarified its inflation
objective, and this change was implemented smoothly.
Would this proposal provide a sufficient degree of commitment to the nominal
anchor?
By stating its intention not to modify the mandate-consistent inflation rate without a clear
technical rationale, I believe that the FOMC would provide a firm nominal anchor that would
not differ much in practice from some alternative commitment to a specific numerical inflation
objective. In explaining this view, I want to draw on some conversations with my son, who is
currently enrolled in law school, and to take advantage of the opportunity to demonstrate my
erudition by using a bit of Latin. (As you may know, I've already demonstrated my command
of Yiddish in another recent speech.33)
stare
In this instance, the relevant legal term is decisis, which means "to stand by things
decided."34 This concept plays a crucial role in the functioning of our legal system: When the
Supreme Court makes a decision in any given case, the reasoning behind that decision
serves as a precedent that guides all subsequent legal considerations, except for particular
circumstances in which the Supreme Court finds compelling reasons for modifying or
overturning a prior decision. The approach that I have recommended here would operate in a
roughly similar way. Because the consensus on the mandate-consistent inflation rate would
be very transparent, the FOMC would not be inclined to modify that consensus value except
for sound economic reasons; hence, this proposal would be sufficient to provide a firm