Richard W Fisher: Forward guidance (With reference to Monty Python,
Odysseus, Apollo, Paul Fisher, Deng Xiaoping and Mario Draghi's Old
Man)
Remarks by Mr Richard W Fisher, President and Chief Executive Officer of the Federal
Reserve Bank of Dallas, before the Asia Society Hong Kong Center, Hong Kong, 4 April
2014.
* * *
The views expressed by the author do not necessarily reflect official positions of the Federal Reserve System.
Thank you, Alice (Mong). It is always an honor to speak before the Asia Society anywhere in
the world but especially here in Hong Kong, one of my favorite cities. I was in Hong Kong
during the transition ceremonies in 1997 when the White House called to ask if I would
become deputy U.S. trade representative. It was a position in which I served for four years
under President Clinton, and it put me on the path to high-level public service. That and my
love for the spectacular food here have cemented Hong Kong in my heart. Thank you for
inviting me to stop here on my way to Beijing.
I want to talk today about "forward guidance" in monetary policy. It is the subject du jour of
central bankers. We've seen it popularized by the Bank of Canada and Bank of England, and
it figured prominently in the statement recently released by the Federal Open Market
Committee (FOMC) of the Federal Reserve after our meeting of March 18-19 and again
during the post-meeting press conference of the Fed Chair, Janet Yellen. It is front and
center on the agenda of the FOMC.
To understand forward guidance and its prominence in current discussions within monetary
policy circles, it helps to retrace recent history.
Adieu quantitative easing
To encourage economic recovery from the debacle of the financial crisis of 2007-09, the
FOMC cut interest rates to near zero. The Fed introduced an array of special lending
facilities during the most panicked stage of the crisis. These credit and liquidity programs
were largely self-liquidating as market functioning improved. But still being "zero bound," we
embarked upon a program of massively expanding the Fed's balance sheet, referred to
internally as "large-scale asset purchases" and popularly known as quantitative easing (QE).
By buying copious quantities of longer-term U.S. Treasury bonds and mortgage-backed
securities (MBS), our balance sheet has grown from slightly under $900 billion prior to the
crisis to $4.3 trillion at present.
When the Fed buys a Treasury note or bond or an MBS, we pay for it, putting money out into
the economy with the expectation that the money will be used by banks and other creditors
and investors to finance job-creating investment, the purchase of homes and other expansive
economic activity.
Thus far, much of the money we have pushed out into the economy has been stored away
rather than expended to the desired degree. For example, we have seen a huge buildup in
the reserves of the depository institutions of the United States. Less than a fifth of
commercial credit in the highly developed U.S. capital markets is extended through
depository institutions. Yet depository institutions alone have accumulated a total of
$2.57 trillion in excess reserves - money that is sitting on the sidelines rather than being
loaned out into the economy. That's up from a norm of around $2 billion before the crisis.
The Fed's large-scale asset purchases dramatically and more broadly impacted credit
markets. The U.S. credit markets are awash in liquidity.
As of March 14, our par holdings of fixed-rate MBS exceeded 30 percent of the outstanding
stock of those securities. Through these purchases, we have driven down mortgage rates
and helped rekindle the U.S. housing market.
We now own just shy of 24 percent of the stock of Treasury coupon securities. Having
concentrated our purchases of Treasuries further out on the yield curve, and done so in size,
we have driven nominal interest rates across the credit spectrum to lows not seen in over a
half century.
This has allowed U.S. businesses to restructure their balance sheets, manage their earnings
per share through share buybacks financed with bargain-basement debt issuance, bolster
stock prices through enhanced dividend payouts and position themselves for financing
growth once they see the whites of the eyes of greater certainty about their economic future.
By driving nominal interest rates to half-century lows, we have also reduced the hurdle rate
by which future cash flows of publicly traded businesses are discounted. Thus, through
financial engineering, we have helped bolster a roaring bull market for equities: The indexes
for stocks have nearly tripled from the lows reached in March 2009.
Alongside these signs of rebound have been some developments that give rise to caution. I
have spoken of these in recent speeches, echoing concerns I have raised in FOMC
discussions:
• The price-to-earnings (PE) ratio of stocks is among the highest decile of reported
values since 1881. Bob Shiller's inflation-adjusted PE ratio reached 26 this week as
the Standard & Poor's 500 hit yet another record high. For context, the measure hit
30 before Black Tuesday in 1929 and reached an all-time high of 44 before the
dotcom implosion at the end of 1999.1
• Since bottoming out five years ago, the market capitalization of the U.S. stock
market as a percentage of the country's economic output has more than doubled to
145 percent - the highest reading since the record was set in March 2000.
• Margin debt has been setting historic highs for several months running and,
according to data released by the New York Stock Exchange on Monday, now
stands at $466 billion.2
• Junk-bond yields have declined below 5.5 percent, nearing record lows.3
• Covenant-lite lending is becoming more widespread. In my Federal Reserve District,
96 percent of which is the booming economy of Texas, bankers are reporting that
money center banks are lending on terms that are increasingly imprudent.
The former funds manager in me sees these as yellow lights. The central banker in me is
reminded of the mandate to safeguard financial stability. As I said recently in a speech in
Mexico, we must watch these developments carefully lest we become responsible for raising
the ghost of irrational exuberance.
It is clear to me that we have a liquidity pool that is more than sufficiently deep and wide
enough nationwide to finance job-creating capital expansion and reduce labor market "slack."
But that will happen only if and when our fiscal authorities - the Congress and the president
- are able to muster the courage to craft tax, spending and regulatory incentives for
jobcreating enterprises to mobilize liquidity for expansion and payroll growth.
Thus far, inflation has yet to raise its ugly head, and inflation expectations as measured by
consumer surveys and market-traded instruments have remained stolid. However, with each
passing day, constantly adding massive amounts to the monetary base will inevitably present
a significant challenge to the FOMC, which must ultimately manage this high-power money
so that it does not become fuel for sustained inflation above the committee's 2 percent target
once it is activated and flows into the economy.
Thus, I was more than supportive of the collective decision of the FOMC to begin cutting
back on our rate of accumulation of assets beginning in December. Over the course of our
recent meetings, we have cut back from accumulating $85 billion per month in Treasuries
and MBS to a present rate of $55 billion per month. This is still somewhat promiscuous. Even
with the taper, the recent decline of mortgage supply has driven our absorption of the MBS
market to 85 percent of fixed-rate MBS issuance. The fall in net MBS supply is outpacing the
taper.
At the current reduction in the run rate of accumulation, the exercise known as QE3 will
terminate in October (when I project we will hold more than 40 percent of the MBS market
and almost a fourth of outstanding Treasuries). We will then be back to managing monetary
policy through the more traditional tool of the overnight lending rate that anchors the yield
curve.
Enter forward guidance
This is no small matter. Quantitative easing has made life easy not only for corporate
treasurers and homeowners and consumers burdened by debt, but also for money market
operators. It has run up the price of stocks and bonds mostly in straight-line fashion, and it
has taken volatility out of the marketplace, allowing market operators and their clients to
profit with little effort. The question of when and under what conditions the FOMC will begin
to raise the base rate off the floor is understandably of intense interest.
For example, every quarter, FOMC participants each provide forecasts of the year in which
they presently think the target overnight rate will be raised, based on what they individually
consider to be the proper conduct of monetary policy. This has given rise to what I consider a
rabid focus on the economic projections, or "dots," that accompany our FOMC statements on
a quarterly basis. Monty Python could almost have written a sketch on the pundits'
preoccupation with the dots.4
Truth be told, although many of us have econometric models and all of us have a
phenomenal team of economists who help us develop our projections, these estimates are,
in the end, largely guesswork. Especially the further out in time they go. Yet the press and
the markets focus on them as though they were the writ of all-knowing, all-seeing monetary
sages. On Monday night, for example, there was much ado made about Janet Yellen noting
in Chicago that the central tendency of our best guesses was that full employment would be
somewhere between a 5.2 and 5.6 percent unemployment rate.
It is nonetheless helpful to contemplate what may be useful guideposts for deciding when to
raise the base rate and how we may convey this to the markets. And so the FOMC is
grappling with just what, in fact, we can provide the marketplace in the form of forward
guidance about our future modus operandi.
Odysseus or Apollo?
Research papers have addressed this subject. For example, some academic economists
draw on Greek mythology to distinguish different techniques for crafting forward guidance,
making a distinction between Odyssean and Delphic forms of guidance.
The Odyssean model involves committing to a policy rule or to a criterion for choosing
between different policy alternatives. Policymakers tie themselves to the mast of this rule or
criterion, sacrificing some of their short-run freedom of action in order to achieve what they
hope will be superior outcomes over the long term. In monetary policy, commitment can in
theory reduce the risk of future recession and more tightly control medium-horizon inflation
expectations at the cost of a somewhat poorer near-term inflation or unemployment
performance.
Commitments come in lots of different flavors and styles, and forward guidance isn't
necessarily helpful or wise just because it's Odyssean. Tying yourself to the mast isn't an
especially good idea if your ship is sinking, or if enemy forces are directing fire toward your
deck. Committing to a particular path for the funds rate, or to a time schedule for funds-rate
liftoff, is not something in which I or many of my colleagues have any interest. Commitments
that are contingent on future economic conditions, in contrast, enjoy at least some support on
the FOMC. President (Narayana) Kocherlakota of the Minneapolis Fed, for example, has
notably proposed that the committee promise to delay liftoff at least until either the
unemployment rate reaches 5 1/2 percent or forecasted inflation hits 2 1/4 percent (provided
longer-term inflation expectations remain well-anchored, and possible risks to financial
stability remain well-contained).
My own view is that commitments aren't always credible, especially if they purport to extend
far into the future. It's hard to bind future policymakers, and it's difficult to anticipate all the
various economic circumstances that might arise down the road. As a general rule, then, the
further into the future a commitment extends, the vaguer it tends to be. Along these lines, the
FOMC periodically reiterates its commitment to do what it is legally mandated to do: pursue
full employment, price stability and a stable financial system. But getting from there to an
actual prescription for the funds rate isn't straightforward. If it were, FOMC meetings wouldn't
take eight-plus hours of discussion and hundreds of pages of briefing materials.
Delphic forward guidance is less binding than Odyssean guidance. Like the responses of the
oracle of Apollo at Delphi, it is more obscure, more enigmatic. It amounts to saying, "Here's
what we think we are going to want to do if the economy evolves as we currently expect."
Delphic guidance clarifies your current thinking about future policy without making any
promises - even contingent promises.
Our current FOMC statement is chock-full of Delphic guidance. On asset purchases: "If
incoming information broadly supports the committee's expectation of ongoing improvement
in labor market conditions and inflation moving back toward its longer-run objective, the
committee will likely reduce the pace of asset purchases in further measured steps ..." On
the timing of liftoff: "The committee continues to anticipate ... that it likely will be appropriate
to maintain the current target range for the federal funds rate for a considerable time after the
asset purchase program ends ..." On the post-liftoff path of the funds rate: "The committee
currently anticipates that, even after employment and inflation are near mandate-consistent
levels, economic conditions may, for some time, warrant keeping the target federal funds rate
below levels the committee views as normal in the longer run."
As a former practitioner, I can tell you that market operators prefer Odyssean guidance to
Delphic guidance, and within the Odyssean model, tend to prefer inflexible, calendar-based
guidance to guidance that's either conditional or qualitative. Life in my former incarnation
would naturally be much more pleasant if I could dial in the specific dates and levels of
interest rate movements. But as a central banker, I am haunted by a comment made by
Winston Churchill in 1926, shortly before things began to unravel in the global financial
markets. Speaking at the Waldorf Hotel in London, he said: "In finance, everything that is
agreeable is unsound and everything that is sound is disagreeable."5
I worry that the predictability of calendar-based commitments can quite possibly be unsound
in two key dimensions. First, the quantitative moorings may be misplaced - especially given
shifts in economic relationships following the worst downturn since the Great Depression.
Second, I question if it is sound policy to remove all uncertainty or volatility from the market. I
wonder whether being totally predictable may, at best, lead to a false complacency that can
too easily be upset should we need to change course. At its worst, I fear calendar-based
commitments can lead, perversely, to market instability by encouraging markets to
overshoot, as they appear to be doing in some quarters at present. I say "calendar-based
commitments," even though the FOMC has tried to couch its calendar-based guidance in
Delphic language. The problem is that guidance intended to be Delphic is, in practice, often
given an Odyssean interpretation. Whether because of wishful thinking by market operators
or because of policymaker inertia (it's easier to stick with the previously announced plan than
to explain a departure from that plan), the Delphic undergoes metamorphosis and becomes
Odyssean.
Thus, I wonder if anything beyond the Delphic is practicable, as much as I might like to set
our compass on autopilot. But even expressing meaningful forward guidance along more
amorphous lines is challenging.
"We'll see": 摸 石 頭 過 河
The point is: Forward guidance can be a complicated monetary policy tool. I had an
interesting discussion about this two weeks ago with a couple of the members of the Bank of
England's Monetary Policy Committee (MPC). They noted that Chris Giles of the Financial
Times has devoted a substantial amount of thoughtful attention to the discussion of forward
guidance.
In Giles' Money Supply blog post of Oct. 2, 2013, he wrote: "Forget triggers, thresholds,
knockouts and long lists of conditions. Paul Fisher, the Bank of England's head of markets,
says everyone is wrong to think forward guidance is complicated. The policy was
summarized in a single simple sentence of the [Bank of England's] explanatory document, he
said in a speech today. This is the sentence," and I'm quoting Giles quoting Paul Fisher: "In
essence, the MPC judges that, until the margin of slack within the economy has narrowed
significantly, it will be appropriate to maintain the current exceptionally stimulative stance of
monetary policy, provided that such an approach remains consistent with its primary
objective of price stability and does not endanger financial stability."
To a central banker, that may have seemed about as concise a Delphic statement as
possible. But Giles suggested, "I'm sure we can all do better than that." He took a stab at
translating the sentence himself, suggesting that it meant "the MPC will let the recovery run
for as long as it can," but he invited others who might have "better, more elegant and more
accurate translations" to submit them via social media. Later that day, he announced the best
summation received. Forward guidance expressed in a two-word sentence: "We'll see."6
That about sums it up. The FOMC is seeking to make sure that we have a sustained
recovery without giving rise to inflation or market instability. We will conduct monetary policy
accordingly. Regardless of the way we may finally agree at the FOMC to write it out or have
Chair Yellen explain it at a press conference, we really cannot say more than that.
So that's where we are: "We'll see." Or as Deng Xiaoping would have phrased it: "We will
摸 石 頭 過
cross the river by feeling the stones" ( 河). We will feel the stones of the economy
with the bottoms of our feet as central bankers and proceed accordingly.
Draghi's Old Man
At a recent meeting I attended in Frankfurt, Mario Draghi of the European Central Bank told
of a man who needed a heart transplant. The doctor leveled with him that he had several
choices, including the heart of a 75-year-old central banker. "I'll take that one," the man
answered immediately. "Why?" the doctor asked. "Well," said the man, "because it's never
been used."
As was made clear in Chair Yellen's speech in Chicago earlier this week, central bankers
have hearts, and the Fed is working to harness monetary policy to relieve the plight of the
cyclically unemployed. But we also need to be vigilant in making clear that we are obligated
to maintain price stability and that allowing inflation to take grip is a cardinal sin for a central
bank, for it is the cruelest of afflictions for all of society.
Joachim Fels of Morgan Stanley noted that Draghi's little joke serves as a reminder not that
my colleagues and I at the Federal Reserve belong to a heartless tribe but that "central
banking is about making rational, cool-headed and unemotional decisions often under
difficult circumstances"7. We must conduct monetary policy in a cool-headed and
unemotional manner in order to achieve both of the mandates Congress has given us -
preserving price stability and achieving full employment - while avoiding financial market
turbulence.
This is the very best we can offer you, whether you are from ancient Ithaca or Delphi or
modern Hong Kong. Those who think we can be more specific in stating our intentions and
broadcasting our every next move with complete certainty are, in my opinion, clinging to the
myth that economics is a hard science and monetary policy a precise scientific procedure
rather than the applied best judgment of cool-headed, unemotional decision-makers. We will
cross the river that separates us from a normalized economy and a normalized monetary
policy by feeling the stones. We may slip on occasion, but you should not underestimate our
intention to apply whatever talents we possess as policymakers to do what is right to
advance economic prosperity while strictly adhering to our commitment of containing inflation
and maintaining market stability.
Thank you (謝 謝).