Charles L Evans: Monetary policy communications and forward
guidance
Speech by Mr Charles L Evans, President of the Federal Reserve Bank of Chicago, at the
International Research Forum on Monetary Policy Seventh Conference, Frankfurt am Main,
16 March 2012.
* * *
Introduction
Thank you, Chris, for that generous introduction. And thanks to Matt, Günter, Chris and
Thomas for organizing such a great conference. I always enjoy being able to step back into
the research world for a while - as things are going these days, it falls in the category of rest
and relaxation! But another reason I enjoy doing so is that I, like most modern central
bankers around the world, feel strongly about guiding policy with good theoretical and
empirical economics. As you will see by my comments tonight, these linkages have been
especially helpful in dealing with the difficult circumstances policymakers find themselves in
today. Of course, these views will be my own, and not necessarily those of the Federal Open
Market Committee (FOMC) or the Federal Reserve System.
I left graduate school in the late 1980s. U.S. monetary policy rates were around 9 percent. At
the time, this restrictive stance was aimed at lowering inflation, which was running about
4 percent, though there was active public debate about how hard policy should press to bring
inflation down. It never crossed my mind back then that one day I would be working on the
problem of how to provide monetary accommodation in an economy with massive
unemployment, very low inflation (perhaps even too low) and a policy rate stuck at the zero
lower bound. With the exception of scholars of the Great Depression, back in the 1980s
today's policy challenges were not on anyone's radar screen.
Of course, that changed with the developments in Japan during the 1990s. More
macroeconomists began thinking about liquidity traps and the monetary policy tools to help
escape from them. These analyses gained momentum following Paul Krugman's Brookings
paper in 1998.1 They focused both on the use of the central bank's balance sheet to provide
accommodation and on communication about policy goals and forward guidance about the
path for policy instruments. Much of this latter work was done within the New Keynesian
paradigm, since communications are central to the policy transmission mechanism in those
models.2 For obvious reasons, such research has come back into vogue today.
The nonstandard policies emphasized by these lines of research have been important
elements in the Federal Reserve's toolkit over the past four years. The Federal Reserve
engaged in two waves of large-scale asset purchases (March 2009 and November 2010),
and, more recently, extended the maturity of the assets on our books (September 2011). In
August 2011, we added a particular type of forward guidance to our policy, first saying we
would likely keep rates low until mid-2013 and then, in January, indicating that sub-par
economic performance would likely warrant exceptionally low rates until at least late 2014.
Working to complement these efforts and to improve FOMC communications more generally,
we also added two major communications initiatives: A statement of our monetary goals and
long-run strategies, and publication of FOMC participants' projections for the federal funds
rate.
I have strongly supported each of these developments, believing that they improved
transparency and also provided welcome further monetary accommodation for the
U.S. economy. However, as I have been talking about in public for some time, I think there
are additional tools we could use to deliver more effective policy accommodation. In
particular, I would like to see our forward guidance take a different form - one that explicitly
ties liftoff in the funds rate to observable economic outcomes (You can think of this as a
Ulysses-type forward guidance: We tie ourselves to the mast to avoid the siren calls of
premature tightening.) As I will talk about shortly, I believe such policy could provide more
clarity about our attitudes toward providing monetary accommodation - and would be more
in line with a structure I would have preferred to have seen in our August 2011 and January
2012 actions. This policy also can be structured in a way that would represent a balanced
risk-management approach to achieving the dual goals of maximum employment and stable
prices that the United States Congress has mandated to the Federal Reserve.
Communications enhancements
First, though, I'd like to discuss the Fed's latest initiatives to enhance communications. As an
accountable central bank in a democratic society, the Federal Reserve has an obligation to
clearly articulate what it is trying to achieve with monetary policy. I believe that our latest
communications efforts are an important step in further increasing such accountability to the
public, as they reaffirm our commitment to both legs of the dual mandate and describe the
ways in which we will seek to achieve those objectives.
The framework statement
Let's start with the framework statement of our policy goals and long-run strategy. The
framework clarifies how the FOMC interprets our statutory responsibilities for facilitating
maximum employment and price stability in terms of measurable and achievable economic
goals that we aim for over the longer run. We say that the Committee sees a rate of inflation
of 2 percent over the long run as being consistent with the price stability leg. There are two
important ingredients: Our explicit inflation objective is 2 percent, and this is to be achieved
over the long run. As recently as 2005, many FOMC participants preferred to describe a
range of inflation outcomes as being consistent with our inflation mandate instead of stating it
as a single number.3 Our current statement narrows our objective to 2 percent. It also sees
this as an average that we aim to achieve over the long run, in recognition of the obvious
realism that inflation may deviate from this goal from time to time owing to economic
challenges, conflicts in achieving the dual mandate objectives and difficulties in the policy
transmission channels.
The statement also notes that maximum employment is largely determined by nonmonetary
factors, which are difficult to measure and may change over time. Hence, we cannot and do
not specify a fixed, time-invariant goal for it. But FOMC participants can provide their current
assessments of goal variables related to the achievement of maximum employment. We do
so using the central tendency of FOMC participants' projections for the rate that
unemployment would converge to in the absence of further shocks to the economy. As of
January 2012, this rate is 5-1/4 to 6 percent.
The statement also indicates that policy will seek to mitigate deviations in inflation and
unemployment from these longer-run goals, and addresses the weighting of relevant costs
and benefits when trying to close these gaps. Namely, if the policy prescriptions for achieving
the inflation and unemployment goals are in conflict, we will take a balanced approach
promoting the return to each, taking into account the size of the deviations and the relative
speeds at which convergence can be expected. As we all know in this audience, there is an
enormous literature related to characterizing the monetary policy loss function for a central
bank with a dual mandate - such as work by John Taylor, Lars Svensson and Michael
Woodford.4 For me, our Federal Reserve dual mandate responsibilities are well captured by
a quadratic loss function that equally weights squared deviations of inflation and
unemployment from their period goal values. In the U.S. today, that would be 2 percent for
inflation and 5-1/4 to 6 percent for unemployment given today's structural challenges in the
labor market.5
Just about every major central bank around the world publishes something akin to such a
framework statement. In one way, the Federal Reserve is different because, unlike other
countries, we have a dual mandate, and so our framework explicitly addresses goals for both
inflation and the real side of the economy. But just about every bank with a single price
stability mandate also says that it will avoid undue disruptions to the real side of the economy
when pursing its inflation goal. Indeed, some are quite clear about following a flexible
inflation targeting strategy.
Policy projections
What about the policy projections? The forecasts for growth, the unemployment rate, and
inflation that FOMC participants have been submitting since 1979 have always been
conditioned on each participant's views of the future path of policy most likely to foster
outcomes consistent with our dual mandate responsibilities - what we refer to as the
appropriate path for policy. As of last January, our quarterly Summary of Economic
Projections (SEP) now include the projected paths for the federal funds rate and qualitative
information about the balance sheet that make up these views.
I believe this move significantly enhances policy accountability. For example, suppose
inflation were running higher than we would like, and the economic projections in the SEP
showed it coming down over the next couple of years. In the absence of policy projections,
the public would not know whether the FOMC thought inflation would simply come down on
its own or whether it thought that a monetary tightening would be required to reduce
inflationary pressures. The inclusion of participants' policy projections will help communicate
such judgments.
Furthermore, households and businesses will be able to make better informed decisions if
they have a clearer notion of future policy rates; the potential for reduced uncertainty could
also lower the risk premium embedded in longer-term interest rates. Now, clearly, our
forecasts of what rates are going to be three years from now will often be wrong - and
sometimes by a good deal. Some say this means our projections are worthless, or, even
worse, will cause people to underweight interest rate risk in making economic decisions. I
disagree. The accuracy of the early forecasts we write down is not so important as how the
public can observe the forecasts change over time. As the economy is hit by shocks or the
data come in contrary to expectations, we will change our forecasts for both the economic
variables and the policy rate. As we do, households and businesses will be able to learn
more about the monetary policy reaction function. And it is this knowledge that will help them
make better informed decisions.
Another criticism we heard on the day the projections were published was that they seemed
to be inconsistent with the FOMC policy statement released a couple of hours earlier. The
statement indicated that the Committee thought economic conditions are likely to warrant
exceptionally low levels for the federal funds rate at least through late 2014, but six of the
17 policy projections showed that the funds rate would be 1-1/2 percent or higher at the end
of that year. Well, by the next day, the markets had figured it out; the projections are made
by all FOMC participants, while the statement reflects the policy views agreed upon at the
meeting by the voting members of the Committee. We all come into the meeting with our
projections, but we then do have a real meeting: All of the participants exchange ideas and
argue points of views, and then the voters on the Committee come to a consensus and make
a collective policy decision. The information regarding the federal funds rate in the SEP does
not substitute for this formal decision of the voting members of the FOMC.
That said, the diversity of views is a fact of life. Policymakers may well have differing
judgments on the appropriate stance of monetary policy in the particular economic
circumstances of the moment. These communications initiatives cannot eliminate these
differences of opinion. But they further discipline the parameters of our discussions, clarify
the judgments that underlie our policy decisions and enhance transparency and the public's
ability to evaluate current monetary policy with alternative approaches.
Forward guidance and policy commitment in an explicit state-contingent policy
The macroeconomic environment
The new policy tools can also complement the kinds of accommodative policies I have been
advocating for some time. The U.S. is now more than two and a half years into its modest
and uneven recovery from the Great Recession. Real gross domestic product growth has
averaged just 2-1/2 percent. The unemployment rate is 8-1/4 percent - well above the rate
anyone on the FOMC sees as being consistent with our longer-run goal; in my view, this is a
substantially higher rate than one might attribute to supply-side factors, such as extended
unemployment insurance and a heightened degree of mismatch in labor markets.
Realistically, this is a 2-1/4 to 3 percentage point deviation from our current maximum
employment objective. Because this occurred with nominal interest rates stuck at the zero
lower bound since December 2008, I believe it's hard to say that we are not in a liquidity trap.
Recently, the U.S. data have been more encouraging, with the labor market improving and
private demand showing a little more traction. Without a doubt, these are welcome
developments. But even the more optimistic forecasts see output increasing only moderately
above its potential growth rates; no one has an expectation for a surge in activity that would
quickly close resource gaps.
At the same time, the outlook for inflation is subdued, with most FOMC participants' forecasts
for increases in total personal consumption expenditures prices averaging roughly between
1-1/2 and 2 percent over the next three years. Furthermore, private sector long-run inflation
expectations are quite well anchored.
As we know from the work of Michael Woodford and Gauti Eggertsson, Ivan Werning,
Paul Krugman6 and others, the optimal policy response to a liquidity trap may involve a
commitment to keep policy rates quite low for a period of time after the real equilibrium rate
has risen enough so that the zero lower bound is no longer binding. This is a strong form of
forward guidance akin to Ulysses tying himself to the mast to avoid changing his mind upon
hearing the siren's seductive music. Of course, in the real world, we cannot observe the
equilibrium real rate, and so we cannot directly implement such a policy. We can capture the
spirit of these recommendations, however, by committing to keep policy rates exceptionally
low until certain observable economic triggers are met that would be consistent with the
economy being well past the liquidity trap.
At the same time, some worry that the output gap and overall resource slack is small. I don't
subscribe to this view. But what if it were true? What kind of new information might we learn
that would change our views about the magnitude of resource slack? Well, in the 1970s, we
learned the hard way that underestimating resource slack and running full out
accommodative monetary policies will lead to unacceptably high inflation. So, in designing a
policy to close resource gaps, I am going to take a careful look at the evolution of inflation
and inflationary expectations to tell me if I am wrong about my assessment of the real-side
shortfalls we need to fill.
An explicit state-contingent policy
Let me outline how this approach might work in practice. The Fed could sharpen its forward
guidance by pledging to keep policy rates near zero until one of two events occurs. The first
event would be if the unemployment rate moved below a 7 percent threshold. Reductions in
the unemployment rate below this level would represent good progress toward the natural
rate of unemployment; depending upon the state of inflation expectations, it might be time to
lessen policy accommodation.7
The second event that would commit us to raise rates would be if inflation rises above a
particular threshold that is clearly unacceptable. This trigger would be a safeguard against
the possibility that our assessments of economic conditions and resource slack are wrong
and the natural rate of unemployment is higher than 7 percent. If this were so, our
experience from the 1970s suggests that a continuation of the low-rate policy would generate
a further unexpected increase in inflation; by adjusting policy according to this trigger, the
Fed would begin exiting from what would now evidently be excessive policy accommodation.
We would not have the desired reductions in unemployment, but then again, there wouldn't
be anything that monetary policy could do about it.
I would argue that this inflation-safeguard threshold needs to be well above our current
2 percent inflation objective. This is consistent with the theoretical work showing that
extraction from a liquidity trap requires the central bank, if necessary, to allow inflation to run
higher than its target over the medium term. My preferred inflation threshold is a forecast of
3 percent over the medium term. For a central bank like the Federal Reserve that has a
statutory dual mandate, this seems like a risk that we should be willing to accept. We would
suffer some net policy loss if the gains in employment did not occur. But we certainly have
experienced inflation rates near 3 percent in the recent past and have weathered them well.
Such an experience would not be anything close to the debilitating higher inflation rates we
saw in the 1970s or 1980s. And 3 percent isn't high enough to unhinge long-run inflation
expectations. Indeed, I think our new framework commitment to a 2 percent long-run inflation
goal would help anchor inflation expectations if we undertook this policy strategy.
Let me also emphasize that under this policy proposal, inflation reaching 3 percent is only a
risk - and not a certainty. Indeed, simulations of standard models suggest that inflation is
likely to remain below 3 percent even under a policy of extended monetary accommodation.
Why I prefer the state-contingent policy to calendar-date guidance
I voted for the mid-2013 guidance we put forward last August and supported the extension to
late 2014 made in January because I felt these actions would provide a greater degree of
accommodation than markets were pricing in at the time. But I think a 7/3 threshold policy
would more clearly convey a commitment to the degree of accommodation I think we need.
There has been much talk about the economic conditionality underlying our calendar-year
guidance - the phrase in our FOMC statement that says the Committee "anticipates that
economic conditions ... are likely to warrant" that precedes the late 2014 forward-guidance
date. But those conditions have not been spelled out. Suppose as we move through next
year that our projections for 2014 have an unemployment rate above 7 percent and inflation
close to 2 percent. Some might argue then that the economic conditionality in the statement
has been met and we should begin to remove accommodation. To me, in the absence of
some new compelling evidence about the natural rate of unemployment or an unhinging of
inflation expectations, this would represent an unwarranted tightening of policy. (Indeed, the
mere chance that this may occur may be diminishing the degree of accommodation in place
today.) The economic thresholds I am proposing put a higher and more predictable standard
on the removal of accommodation.
Conclusion
I would like to conclude by noting that I have undoubtedly generated some discomfort in the
room tonight by saying that even with the large degree of accommodation already in place,
monetary policy can and should take additional steps to facilitate a more robust economic
expansion.
Central bankers naturally worry about such statements. We think back to the 1970s, when
our failure to appreciate the changing structure of the economy led to over-stimulative policy
and eventually to stagflation. It's in our DNA to have these concerns; and they remind us of
the need to continually do our best to calibrate important markers such as the natural rate of
unemployment, keep close tabs on inflation expectations and have our eyes open for early
warning signs of financial instability.
But I believe a greater risk today is that we buy too quickly into thinking that the equilibrium
rate of unemployment has jumped 2 or 3 percentage points or that long-run inflation
expectations have become so fragile that they are on the verge of spiking well above
2 percent. I just don't see the evidence out there supporting this view. But if we do buy into it,
then we'll end up following overly restrictive policies that could unnecessarily risk
condemning the U.S. economy to a lost decade - or even more. And the costs of taking this
route would be unacceptable.
References
Bernanke, Ben S., Vincent R. Reinhart and Brian P. Sack, 2004, "Monetary policy
alternatives at the zero bound: An empirical assessment(external)," Brookings Papers on
Economic Activity, Vol. 35, No. 2, pp. 1-78, available by subscription.
Eggertsson, Gauti B., and Michael Woodford, 2003, "The zero bound on interest rates and
optimal monetary policy(external-pdf)," Brookings Papers on Economic Activity, Vol. 34,
No. s1, pp. 139-211.
Federal Open Market Committee, 2005, Meeting transcript(external-pdf), February 1-2.
Krugman, Paul R., 1998, "It's baaack: Japan's slump and the return of the liquidity trap,"
Brookings Papers on Economic Activity, Vol. 29, No. 2, pp. 137-206.
Svensson, Lars E. O., 1997, "Optimal inflation targets, 'conservative' central banks and linear
inflation targets," American Economic Review, Vol. 87, No. 1, March, pp. 98-114.
Taylor, John B., 1979, "Estimation and control of a macroeconomic model with rational
expectations," Econometrica, Vol. 47, No. 5, September, pp. 1267-1286.
Woodford, Michael, 2003, Interest and Prices: Foundations of Monetary Policy, Princeton,
NJ: Princeton University Press.
Werning, Ivan, 2011, "Managing a liquidity trap: Monetary and fiscal policy (external),"
National Bureau of Economic Research, working paper, No. 17344, August.