Jeremy C Stein: Challenges for monetary policy communication
Speech by Mr Jeremy C Stein, Member of the Board of Governors of the Federal Reserve
System, at the Money Marketeers of New York University, New York City, 6 May 2014.
* * *
The views expressed here are my own and are not necessarily shared by other members of the Federal Reserve
Board or the Federal Open Market Committee. I am grateful to William English for helpful comments.
The Money Marketeers have a long tradition of hosting policymakers and fostering informed
public discussion, and I am delighted to join in this tradition.
Last month I announced that I would be leaving the Federal Reserve Board at the end of
May in order to return to my teaching position at Harvard. So I would like to take a moment to
express my gratitude to my many colleagues at the Board and around the Federal Reserve
System who have taught me so much - not just about economic policy, but about public
service. It has been a privilege to work alongside such a talented and selfless group of
people and to be a part of such a special institution.
One of the many aspects of the job that I had not fully appreciated before joining the Board is
how challenging the whole process of communicating about monetary policy can be. As you
know, over the past several years the Federal Reserve has dramatically altered how it talks
to financial markets and to the public at large. For much of its 100-year history, the Fed was
remarkably opaque; indeed, around the time I started my academic career in the mid-1980s,
there was an active literature on the causes and consequences of such opacity. The title of
Marvin Goodfriend's 1986 paper captured the situation well: "Monetary Mystique: Secrecy
and Central Banking."1 In the 1990s, however, the Fed began to move toward greater
transparency, with the Federal Open Market Committee (FOMC) providing more timely
information about its policy decisions.
This evolution in the direction of greater openness has continued. And, in the last 10 years,
there have been numerous changes in the FOMC's communications policies: accelerated
release of the minutes, an increase in the frequency and scope of participants' economic
projections, and the introduction of postmeeting news conferences, to name a few.
These are all welcome developments, and I expect there will be further changes down the
road, as the Committee keeps trying to improve how it explains its policy decisions to the
public. In this spirit, I would like to spend the rest of my time discussing a few of the things
that make life interesting for those trying to communicate clearly and effectively about
monetary policy.
More specifically, I am going to touch on three factors that strike me as particularly relevant
for our efforts in this area: the fact that the market is not a single person, the fact that the
Committee is not a single person either, and the delicate interplay between the Committee
and the market.
The market is not a single person
This point was very nicely made by Hyun Shin in his remarks at the Federal Reserve Bank of
Kansas City's symposium at Jackson Hole last summer. Shin wrote:
The "market" is not a person. Market prices are outcomes of the interaction of
many actors, and not the beliefs of any one actor....But most discussions of
central bank forward guidance treat the market as if it were an individual that you
can sit down and reason with....By doing so, I believe we are in danger of
committing a category mistake where we anthropomorphize the "market" as a
rational individual with beliefs.2
Let me give you a particular example that illustrates the wisdom of Shin's observation. In
early May 2013, long-term Treasury yields were in the neighborhood of 1.60 percent. Two
months later, shortly after our June 2013 FOMC meeting, they were around 2.70 percent.
Clearly, a significant chunk of the move came in response to comments made during this
interval by Chairman Bernanke about the future of our asset purchase program. For
example, in his June 19 press conference, he said:
If the incoming data are broadly consistent with this forecast, the Committee
currently anticipates that it would be appropriate to moderate the monthly pace of
purchases later this year. And if the subsequent data remain broadly aligned with
our current expectations for the economy, we would continue to reduce the pace
of purchases in measured steps through the first half of next year, ending
purchases around midyear.3
Perhaps it is not surprising that news about the future course of the asset purchase program
would have a strong effect on markets. But here is the striking fact: According to the Survey
of Primary Dealers conducted by the New York Fed, there was hardly any change over this
period in the expectation of the median respondent as to the ultimate size of the program.4
Chairman Bernanke's comments may have clarified the FOMC's intentions, but, according to
the survey, they did not have any clear directional implications for the total amount of
accommodation to be provided via asset purchases. Thus, FOMC communications in this
period did not appear to be meaningfully hawkish.
So what gives? One hypothesis is that going into the May-June period, there was a wide
divergence of opinion among market participants as to the future of the asset purchase
program. In particular, however reasonable the median expectation, there were a number of
"QE-infinity" optimists who expected our purchases to go on for a very long time. And,
crucially, in asset markets, it is often the beliefs of the most optimistic investors - rather than
those of the moderates - that drive prices, as they are the ones most willing to take large
positions based on their beliefs. Moreover, this same optimism can motivate them to
leverage their positions aggressively.5
In this setting, a piece of monetary policy communication that merely "clarifies" things - that
is, one that delivers the median market expectation but truncates some of the more extreme
possibilities - can have powerful effects. Highly levered optimists are forced to unwind their
positions, which then must be absorbed by other investors with lower valuations. This effect
is likely to be amplified if the preannouncement period was one with unusually low volatility,
as was the case in early May 2013, when the implied volatility on long-tenor swaptions was
near historical lows. To the extent that some of the optimists are operating subject to value-
at-risk constraints, low volatility is likely to induce them to take on more leverage. If volatility
rises sharply in the wake of an announcement, this increase will tend to exacerbate the
unwind effect.
To be clear, I am not saying that monetary policy communications should have been different
during this period. Rather, the point is that in some circumstances there are very real limits to
what even the most careful and deliberate communications strategy can do to temper market
volatility. This is just the nature of the beast when dealing with speculative markets, and to
suggest otherwise - to suggest that, say, "good communication" alone can engineer a
completely smooth exit from a period of extraordinary policy accommodation - is to create an
unrealistic expectation.
In this spirit, I think the FOMC may face a similar communications challenge as the nature of
the forward guidance for the path of short-term interest rates evolves over the next couple of
years. The 6.5 percent unemployment threshold that we had until recently was not only
quantitative in nature, but it also represented a relatively firm commitment on the part of the
Committee. While this kind of commitment was entirely appropriate at the zero lower bound,
as policy eventually normalizes, guidance will necessarily take a different form; it will be both
more qualitative as well as less deterministic. So, for example, when I fill in my "dot" for 2016
in the Survey of Economic Projections, I think of myself as writing down not a commitment for
where the federal funds rate will be at that time, but only my best forecast, and one that is
highly uncertain at that.
Chair Yellen made a similar point in her March press conference:
More generally, you know, the end of 2016 is a long way out. Monetary policy will
be geared to evolving conditions in the economy, and the public does need to
understand that as those views evolve, the Committee's views on policy will likely
evolve with them. And that's a kind of uncertainty that the Committee wouldn't
want to eliminate completely from its guidance because we want the policy we
put in place to be appropriate to the economic conditions that will prevail years
down the road.6
I agree completely with this view, and I suspect that many in the market also understand the
distinction that is being drawn - that as policy normalizes, forward guidance will be less
commitment-like and, hence, a less precise guide to our future actions than it has been in the
recent past. But I would not want to presume that everybody is thinking about it the same
way; one can imagine that there might again be some optimists who are in this case
underestimating the degree of uncertainty about the future path of policy and are placing
levered bets accordingly. So we may have some further bumps in the road as this all plays
out.
The committee is not a single person
It is common to hear observers talk about the Committee's reaction function, which describes
how we will behave in various contingencies. However, even if all of the individual members
of the Committee have well-defined and carefully thought-out individual reaction functions -
that is, each member knows what his or her policy preference is for any given state of the
world - it does not follow that the Committee as a whole has an equally well-defined reaction
function.
The reason for this divergence is that when one says that the Committee has a reaction
function for how it will behave if contingency X arises, such a statement implies that we have
fully litigated this contingency in advance. In other words, we have debated the pros and
cons, we have hashed out our differences, and we have come to an agreement on how to
proceed under contingency X. But such litigation is difficult and sometimes costly, as it may,
for example, take considerable time or lead to a loss of cohesion on other, more pressing
issues. So it may be easier and more efficient to leave our behavior in some important
contingencies for future discussions. Think of why people often forgo prenuptial agreements
when getting married - it is simply too painful to negotiate over every contingency ahead of
time.
This observation is helpful in understanding some of the differences between an open-ended
asset purchase program, such as QE3, and its closed-end predecessors. One advantage of
going with an open-ended approach is that when we rolled out QE3 in September 2012, we
were able to make a forceful statement that we would continue with asset purchases until we
observed, as Chairman Bernanke put it in his postmeeting press conference, a "substantial
improvement in the outlook for the labor market."7 We were able to do so even though I
suspect that, had we tried to put a number to it, there would have been considerable
disagreement among Committee members as to the exact meaning of "substantial
improvement." So in this case, leaving the Committee's reaction function incompletely
worked out allowed us to move forward with a major policy initiative in a timely manner,
which otherwise might have been very difficult.
Of course, the flip side of this reaction-function incompleteness is that it becomes harder for
the Committee to precisely communicate its future intentions to the market - in part because
these future intentions have not yet been fully fleshed out. Rather, it makes more sense in
this case to think of the Committee's reaction function as being something that is not entirely
predetermined and that will naturally tend to evolve over time.
The interaction of the committee and the market
Going further, it is important to note that this evolution of the reaction function does not
happen in a vacuum, where the Committee deliberates in a cloistered fashion and then
simply reports its decisions to the market. All along, the market is making conjectures about
how we will behave, and these conjectures in turn can have a powerful influence on the
debate itself. This feedback effect has been especially relevant in the case of QE3, because
the policy has relied significantly on a signaling channel for some of its effectiveness. That is,
QE3 has, in my view, mattered not just because of the direct downward pressure on
longerterm interest rates associated with removing a given quantity of duration from the private
market, but also because it has buttressed our forward guidance by serving as a credible
signal of the Committee's intentions with respect to the future path of the federal funds rate.
Of course, if the Committee is using asset purchases to signal its policy intentions, then the
information content of purchase decisions depends importantly on what the public expects it
to do. For example, if it is early 2013 and the market has somehow arrived at the belief that
the Committee will continue buying assets at an $85 billion per month clip so long as monthly
payroll growth does not exceed 200,000 jobs per month for three months in a row, then even
a small cut down to $80 billion per month is likely to elicit a powerful market reaction - not
because the $5 billion cut is consequential in and of itself, but because of the message it
sends about the Committee's policy leanings more generally. But then you can see the
feedback loop that arises: The more strongly the market becomes attached to this belief -
even if it was initially somewhat arbitrary - the more wary the Committee must be of making
an unexpected change, and this wariness further reinforces the market's initial belief. In this
sense, the Committee's reaction function for the appropriate quantity of asset purchases
under the QE3 program is not only evolving over time, it is coevolving along with the market's
beliefs.
In part for this reason, I believe we are currently in a very good position with respect to the
market's expectations for our asset purchases going forward. Market participants now
appear to almost uniformly expect that, barring a material change in the outlook for the
economy, the Committee is likely to continue tapering our purchases in further measured
steps over the remainder of this year. With these expectations in place, the execution of the
taper itself becomes much easier, as we no longer have to worry about a step-down at each
meeting sending a potentially misleading message about our intentions with respect to the
future path of the federal funds rate.8
The case of QE3 illustrates the point that the Committee's reaction function is shaped by
market expectations and vice versa. But I suspect that the point has more general
applicability. Consider the well-known phenomenon of "gradualism" in monetary policy,
whereby changes to the policy rate during an easing or tightening cycle tend to come in a
series of small and relatively predictable steps. This phenomenon is reflected in the fact that
the Committee's behavior in normal times can be approximately described by an "inertial"
version of a Taylor rule - one in which, in addition to putting weight on inflation and
unemployment, the Committee also behaves as if it has an aversion to making sudden large
changes in the federal funds rate.
However, such a reduced-form description of the Committee's behavior does not answer the
question of why this kind of inertia might be optimal. Why should the Committee act as if it is
averse to making sharp changes in the funds rate? At one level, the answer is clear: This
behavior is in the service of our mandate, and nothing more. For if we were to make an
unexpectedly abrupt adjustment at any time, it would likely have a large effect on long-term
rates and credit conditions more generally, which in turn might compromise our ability to
reach our goals for employment and inflation - for example, a large bond-market move of
this sort might nip a nascent recovery in the bud, which is why it is to be avoided.
Digging deeper, though, it is important to recognize that part of the reason that the bond
market would react so strongly to a sharp change in the short-term policy rate is that we have
settled into a self-sustaining equilibrium in which the Fed tends to act gradually, and the
market has come to expect that gradualism. In other words, the market has learned that a
given increase in the federal funds rate at the beginning of a tightening cycle is typically
followed by many more moves in the same direction, so there is naturally a multiplier effect
on long-term rates of a given change in short-term rates. And that multiplier depends on the
expected degree of gradualism: The more inertia there is in Fed policy, the more significant
is any small move, and hence the larger is the multiplier. Thus, an expectation of gradualism
on the part of the market makes it all the more important for the Fed to adjust the policy rate
gradually, thereby fulfilling the market's beliefs.
This line of reasoning can be thought of as a piece of positive economics - that is, it may
shed some light on why the world is as it is. But what, if any, are its normative implications?
On the one hand, as I have emphasized, a gradualist approach to monetary policy is likely to
be the best way for us to deliver on our mandate at any point in time, taking as given the
market's expectations for Fed behavior. As such, it would probably not make sense, in the
short run, for the Committee to deviate from this approach - with an unprepared market, the
result might well be an undesirable degree of market turbulence, with attendant negative
effects on the real economy.
On the other hand, there is clearly a time-consistency problem lurking here; the world we are
in need not be the best of all possible worlds. In particular, it is interesting to think about an
alternative long-run equilibrium in which the Fed has somehow developed a reputation for
worrying less about the immediate bond-market effect of its actions and is known to react
more aggressively to changes in economic conditions.9 In this alternative equilibrium, the
market would expect the Fed to behave in a less gradualist fashion, so any given move in the
funds rate would have a smaller multiplier effect on long rates. Thus, it is possible that in this
alternative world, market volatility would be no higher than it is in our world, but the Fed
would nevertheless be able to adjust policy more nimbly when it needed to.
Of course, even if this alternative world is a better place, it may be difficult as an institutional
matter to get from here to there. And I do not have any particularly helpful insights on how
one would make the transition. Nevertheless, I do think there is a useful message to be
borne in mind when thinking about communications strategy more generally. There is always
a temptation for the central bank to speak in a whisper, because anything that gets said
reverberates so loudly in markets. But the softer it talks, the more the market leans in to hear
better and, thus, the more the whisper gets amplified. So efforts to overly manage the market
volatility associated with our communications may ultimately be self-defeating. As we
evaluate our own performance in the communications department, it is probably better for us
to focus on how legitimately transparent we have succeeded in being, as opposed to how
much or how little our various announcements have moved markets.