Monetary policy

Communicating Monetary Policy Uncertainty

When it comes to forecasting, we usually cite famous Yankee catcher and baseball philosopher Yogi Berra, who reputedly said: “It's tough to make predictions, especially about the future.”

For central bankers, this is more than just a minor headache. Given the lags between policy actions and their effects, forecasting is unavoidable. That puts uncertainty about the economic outlook at the heart of the policymakers’ daily job. Indeed, no one knows the future path of the economy or interest rates—not even those making the decisions.

Communicating this inevitable monetary policy uncertainty is difficult, but essential. In the United States, the Federal Open Market Committee (FOMC) uses a variety of means for this purpose. In two earlier posts, we discussed the evolution of FOMC communications and the usefulness of the quarterly survey of economic projections (SEP). Here, we examine a key aspect of FOMC communications that receives insufficient attention: the explicit publication of policymakers’ range of uncertainty about the future path for the policy rate. Buried near the end of the FOMC minutes, published three weeks after the SEP release, this information is consumed only by die-hard devotees….

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Dot-ology: What can we learn from the dot plot?

The primary objective of monetary policy is to keep inflation and unemployment low and stable. To be effective, central bankers must address shocks to inflation and unemployment, while ensuring that what they say and do is not a source of volatility. One way to make a commitment to stability credible is for policymakers to broadcast their likely responses to shocks—their reaction function. Such transparency escalates the cost of reneging, helping to anchor expectations about the future that influence current behavior (see our primer on time consistency). And, because they can anticipate how policy will respond to changes in economic and financial conditions, it improves everyone’s economic and financial decisions.

With such a stability-oriented policy strategy, the policy path will depend on what happens in a changing world. Only under specific circumstances―such as when the short-term interest rate is at or near its effective lower bound―will policymakers be inclined to commit to a specific future policy path.

Recently, we wrote about the remarkable evolution of Federal Reserve monetary policy communication over the past quarter century. Today, the Federal Open Market Committee (FOMC) publishes statements, minutes, and quarterly forecasts for growth, inflation, unemployment, and interest rates. In this post we take up a narrow question: What can we learn from the information published in the FOMC’s quarterly Summary of Economic Projections (SEP)?

Our answer is: quite a bit. The data allow us to estimate not only an FOMC reaction function, but also a short-run projection of the equilibrium real rate of interest (r*)―one that is consistent with projected economic conditions over a two- to three-year horizon—in addition to the long-run r* that is implicit in each SEP. While there is almost surely room to improve on the SEP, we conclude, as a friend and expert Fed watcher once suggested, “Don’t ditch the dots” ….

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Inflation risks and inflation expectations

U.S. inflation has been low and steady for three decades. This welcome stability is not merely a consequence of good fortune. Shocks that in the past might led to higher trend inflation—like the energy price increases—continue to buffet the economy much as they did in the 1970s and 1980s, when inflation rose to a peacetime record. Rather, it reflects the improved monetary policy of the Federal Reserve, which began acting as an inflation-targeting central bank in the mid-1980s, long before it announced a 2% target for inflation in 2012. As a consequence of the Fed’s sustained efforts, long-run inflation expectations have remained close to 2% for more than 20 years. One result is that temporary disturbances that drive inflation above or below target quickly fade.

This is the optimistic conclusion of the 2017 U.S. Monetary Policy Forum (USMPF) report. Since the adoption of the de facto inflation-targeting regime, one-off shocks have little impact on the inflation trend. Moreover, as many have observed, the relationship between unemployment and inflation—the Phillips curve (see our primer)—is now notably weaker. However, the authors of that earlier report warn that the Phillips curve “flattening” could be a direct consequence of the Fed’s success. Furthermore, since the sample period from 1984 to 2016 excludes any sustained period of a very tight economywide labor market, it would not be possible to detect an outsized impact, if any, of persistently low unemployment on inflation.

Enter the 2019 USMPF report, which focuses on the possibility that inflation may indeed respond differently when the unemployment rate is very low and projected to remain low for several years (see, for example the FOMC’s latest Summary of Economic Projections). The logic is straightforward: if labor is very scarce for an extended period, employers will bid up wages and (unless they are prepared to accept declining profits) pass on those cost increases in the form of higher prices….

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FOMC Communication: What a Long, Strange Trip It's Been

Following their January 2019 meeting, the Federal Open Market Committee (FOMC) came in for intense criticism. Instead of a truculent President complaining about tightening, this time it was financial market participants grumbling about a sudden accommodative shift. In December 2018, Fed policymakers’ suggested that, if the economy and market conditions evolved as expected, they probably would raise interest rates further in 2019. Faced with changes in the outlook, six weeks later they altered the message, suggesting that going forward, monetary easing and tightening were almost equally likely.

We find the resulting outcry difficult to fathom. The FOMC’s perceptions of the outlook may have been incorrect in December, in January, or both. There are myriad ways for economic and market forecasts to go wrong. But, to secure their long-run objectives of stable prices and maximum sustainable employment, isn’t it sometimes necessary for policymakers to change direction, and when they do, to explain why?

The point is that the recent turmoil arises at least in part from the Fed’s high level of transparency. In this post, we summarize the evolution of Federal Reserve communication policy over the past 30 years, and discuss the importance and likely impact of these changes. While transparency is far from a panacea, we conclude that the evolution has been useful for making policy more effective and sustainable, and remains critical for accountability and democratic legitimacy….

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Navigating in Cloudy Skies

Stargazers hate clouds. Even modest levels of humidity and wind make it hard to “see” the wonders of the night sky. Very few places on our planet have consistently clear, dark skies.

Central bankers face a similar, albeit earthly, challenge. Even the simplest economic models require estimation of unobservable factors; something that generates considerable uncertainty. As Vice Chairman Clarida recently explained, the Fed depends on new data not only to assess the current state of the U.S. economy, but also to pin down the factors that drive a wide range of models that guide policymakers’ decisions.

In this post, we highlight how the Federal Open Market Committee’s (FOMC’s) views of two of those “starry” guides—the natural rates of interest (r*) and unemployment (u*)—have evolved in recent years. Like sailors under a cloudy sky, central bankers may need to shift course when the clouds part, revealing that they incorrectly estimated these economic stars. The uncertainty resulting from unavoidable imprecision not only affects policy setting, but also complicates policymakers’ communication, which is one of the keys to making policy effective….

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U.S. Monetary Policy Spillovers

Do changes in U.S. dollar interest rates have a material impact on financial conditions elsewhere in the world? The answer is a resounding yes (see the paper one of us presented at this month’s IMF Annual Research Conference). When the Federal Reserve eases, the result is a dramatic increase in financial system leverage in other countries. Not only that, but the impact is larger than that of domestic policy changes.

The outsized cross-border impact of U.S. monetary policy creates obvious challenges for policymakers abroad aiming to maintain financial stability. Governments in the countries most affected have few options to limit the risks created by cyclical changes in dollar interest rates. The available mix of prudential measures includes more stringent capital requirements, limits on foreign currency liabilities, and restrictions on cross-border capital flows. The alternative of trying to counter U.S. monetary stimulus through higher policy interest rates abroad may backfire….

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Negative Nominal Interest Rates and Banking

The financial crisis of 2007-2009 taught us many lessons about monetary policy. Most importantly, we learned that when financial systems are impaired, central banks can backstop both illiquid institutions and illiquid markets. Actively lending to solvent intermediaries against a broad range of collateral, purchasing assets other than those issued by sovereigns, and expanding their balance sheets can limit disruptions to the real economy while preserving price stability.

We also learned that nominal interest rates can be negative, at least somewhat. But in reducing interest rates below zero―as has happened in Denmark, Hungary, Japan, Sweden, Switzerland and the Euro Area―policymakers face concerns about whether their actions will have the desired expansionary effect (see here). At positive interest rates, when central bankers ease, they influence the real economy in part by expanding banks’ willingness and ability to lend. Does this bank lending channel work as well when interest rates are negative?

Why should there be any sort of asymmetry at zero? Banks run a spread business: they care about the difference between the interest rate they charge on their loans and the one they pay on their deposits, not the level of rates per se. In practice, however, zero matters because banks are loathe to lower their deposit rates below zero….

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Trump v. Fed

Last month, interrupting decades of presidential self-restraint, President Trump openly criticized the Federal Reserve. Given the President’s penchant for dismissing valuable institutions, it is hard to be surprised. Perhaps more surprising is the high quality of his appointments to the Board of Governors. Against that background, the limited financial market reaction to the President’s comments suggests that investors are reasonably focused on the selection of qualified academics and individuals with valuable policy and business experience, rather than a few early-morning words of reproof.

Nevertheless, the President’s comments are seriously disturbing and—were they to become routine—risk undermining the significant benefits that Federal Reserve independence brings. Importantly, the criticism occurred despite sustained strength in the economy and financial markets, and despite the stimulative monetary and fiscal policies in place….

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Inflation Policy

Inflation in the United States remains at levels that most people don’t really notice. Overall, the consumer price index rose 2.8 percent from May 2017 to May 2018. And, when you look at core measures, the trend is still below 2 percent.

With inflation and inflation expectations still so benign, it is no wonder that despite solid economic growth and the lowest unemployment rate in 50 years the Federal Open Market Committee continues to act quite gradually (see their June 2018 statement). Inflation could well turn up in the near term—perhaps by more than the policymakers expect. But, for reasons that we will explain, if we were on the FOMC, we would stay the planned course: remain vigilant, but certainly not panic.

We start with a look at the data. What we see is that trend inflation has stayed reasonably close to the Fed’s medium-term target of 2 percent for the past two decades. There have been occasional deviations, like the temporary rise in 2008 and again in 2011, but overall, the path is remarkably stable….

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Making Unelected Power Legitimate

Through what administrative means should a democratic society in an advanced economy implement regulation? In practice, democratic governments opt for a variety of solutions to this challenge. Historically, these approaches earned their legitimacy by allocating power to elected officials who make the laws or directly oversee their agents.

Increasingly, however, governments have chosen to implement policy through agencies with varying degrees of independence from both the legislature and the executive. Under what circumstances does it make sense in a democracy to delegate powers to the unelected officials of independent agencies (IA) who are shielded from political influence? How should those powers be allocated to ensure both legitimacy and sustainability?

These are the critical issues that Paul Tucker addresses in his ambitious and broad-ranging book, Unelected Power. In addition to suggesting areas where delegation has gone too far, Tucker highlights others—such as the maintenance of financial resilience (FR)—where agencies may be insufficiently shielded from political influence to ensure effective governance. His analysis raises important questions about the regulatory framework in the United States.

In this post, we discuss Tucker’s principles for delegating authority to an IA. A key premise—that we share with Tucker—is that better governance can help substitute where simple policy rules are insufficient for optimal decisions….

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Universal Central Bank Digital Currency?

Digital currency is all the rage. Bitcoin has more than one thousand crypto cousins. There is even a token called dentacoin, whose issuers claim it will transform dentistry! In the past, we have been clear in our views. We agree with BIS General Manager Agustín Carstens: these are exactly like past attempts of people to issue their own private money. As Carstens said on another occasion, these tokens are “a combination of a bubble, a Ponzi scheme and an environmental disaster.”

Regardless of whether the blockchain will revolutionize dental health, the appearance of cryptocurrencies has driven central banks to think about one particular aspect of their business: paper currency issuance.

In this post, we expand on some aspects of our earlier discussion of central bank digital currency (CBDC). What is it and what would its wider introduction mean for the financial system? Our conclusion is unambiguous: Watch out what you wish for! ….

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Liquidity Regulation is Back

Modern bank regulation has two complementary parts: capital and liquidity requirements. The first  restricts liabilities given the structure of assets and the second limits assets based on the composition of liabilities.

While capital regulation―especially in its risk-based form―is a creation of the last quarter of the 20th century, liquidity regulation is much older. In fact, the newly implemented liquidity coverage ratio (LCR) harks back to the system in place over 100 years ago. In the United States, before the advent of the Federal Reserve in 1914, both national and state-chartered banks were required to hold substantial liquid reserves to back their deposits (see Carlson). These are the reserve requirements (RR) that remain in effect in most jurisdictions today, the United States included.   

In this post, we briefly examine the long experience with RR as a way to gain insight regarding the LCR. We draw two conclusions. First, we argue strongly against using the LCR as a monetary policy tool in advanced economies with well-developed financial markets. Like RR, it is simply too blunt and unpredictable. Second, for the LCR to work as a prudential policy tool, it should probably be supplemented by something like a fee-based line of credit at the central bank....

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Relying on the Fed's Balance Sheet

Last week’s 12th annual U.S. Monetary Policy Forum focused on the effectiveness of Fed large-scale asset purchases (LSAPs) as an instrument of monetary policy. Despite notable disagreements, the report and discussion reveal a broad (if not universal) consensus on key issues:

In a world of low equilibrium real interest rates and low inflation, policymakers could easily hit the zero lower bound (ZLB) in the next recession.

At the ZLB, the Fed should again use a combination of balance-sheet tools and interest-rate forward-guidance to achieve its mandated objectives of stable prices and maximum sustainable employment (see our earlier post).

Yet, significant uncertainties about the impact of balance-sheet expansion mean that LSAPs may not provide sufficient stimulus at the ZLB.

Fed policymakers should undertake a thorough (and potentially lengthy) assessment of alternative policy tools and frameworks—ranging from negative interest rates to a higher inflation target to forms of price-level targeting—to ensure they remain as effective as possible.

The remainder of this post discusses the challenges of measuring the impact of balance-sheet policies. As the now-extensive literature on the subject implies, balance-sheet expansions ease financial conditions. However, as this year’s USMPF report emphasizes, there is substantial uncertainty about the scale of that impact.... 

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Time Consistency: A Primer

The problem of time consistency is one of the most profound in social science. With applications in areas ranging from economic policy to counterterrorism, it arises whenever the effectiveness of a policy today depends on the credibility of the commitment to implement that policy in the future.

For simplicity, we will define a time consistent policy as one where a future policymaker lacks the opportunity or the incentive to renege. Conversely, a policy lacks time consistency when a future policymaker has both the means and the motivation to break the commitment.

In this post, we describe the conceptual origins of time consistency. To emphasize its broad importance, we provide three economic examples—in monetary policy, prudential regulation, and tax policy—where the impact of the idea is especially notable....

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A Monetary Policy Framework for the Next Recession

Hope for the best, but prepare for the worst. That could be the motto of any risk manager. In the case of a central banker, the job of ensuring low, stable inflation and high, stable growth requires constant contingency planning.

With the global economy humming along, monetary policymakers are on track to normalize policy. While that process is hardly free of risk, their bigger test will be how to address the next cyclical downturn whenever it arrives. Will policymakers have the tools needed to stabilize prices and ensure steady expansion? Because the equilibrium level of interest rates is substantially lower, the scope for conventional interest rate cuts is smaller. As a result, the challenge is bigger than it was in the past.

This post describes the problem and highlights a number of possible solutions.

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Why the central bank should be a leading supervisor

Should central banks be a leading supervisor, including supervising systemically important institutions? This is a question that members of the U.S. Congress periodically raise.  Our answer is unequivocally yes. As the lender of last resort, as the monetary policy authority, and as the organization responsible for overseeing the health and stability of the overall financial system—what we could call a systemic regulator—the central bank needs to be a leading supervisor....

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How to Ensure the Crisis Provision of Safe Assets

Changes in financial regulation are having a profound impact on the demand for safe assets—assets with a fixed nominal value that may be converted at all times without loss into the means of payment. Not only is demand for safe assets on the rise, but the ability of the private sector to produce them is being constrained by new rules that limit the extent and nature of things like securitizations.

So far, the fallout from increased demand and constrained supply looks reasonably benign. But for several years now, broad financial conditions have been very calm, with measures of financial volatility and stress at or near long-term lows. What will happen when the financial system comes under stress again? What if there is a drop in risk tolerance (or a surge in risk awareness) and a flight to safety that causes a jump in the demand for safe assets or a plunge in the supply? Or, as in 2008, what will happen if both materialize at the same time? We need to be ready.

As we will explain in more detail, central banks in advanced economies can satisfy the heightened need for safe assets under stress (as well as the precautionary demand in normal times) by offering commercial banks committed lines of credit for a fee against collateral, as the central banks in Australia and South Africa currently do. In our view, this mechanism for ensuring sufficient supply of safe assets in a crisis has important advantages compared to one in which the central bank operates perpetually—in good times and bad—with a very large balance sheet.

To see how this would work, we start with an explanation of post-crisis liquidity regulation....

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The Phillips Curve: A Primer

Economists have debated the relationship between inflation and unemployment at least since A.W. Phillips’s study of U.K. data from 1861 to 1957 was published 60 years ago. The idea that a tight or slack labor market should result in faster or slower wage gains seems like a natural corollary to standard economic thinking about how prices respond to deviations of demand from supply. But, over the years, disputes about this Phillips curve relationship have been and remain fierce.

As the U.S. labor market tightens, and unemployment approaches levels we have not seen in more than 15 years, the question is whether inflation is going to make a comeback. More broadly, how useful is the Phillips curve as a guide for Federal Reserve policymakers who wish to achieve a 2-percent inflation target over the long run?

To anticipate our conclusion, despite evidence of a negative relationship between wage inflation and unemployment, central banks ought not rely on a stable Phillips curve for setting monetary policy.

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The Fed's Balance Sheet and the Stance of Monetary Policy

U.S. monetary policy is tightening, as everyone who pays even the slightest attention to the financial news knows. But when and how?  Here, the discussion is focused on two complementary aspects of Federal Reserve policy: interest rates and the balance sheet. The first of these concerns policy of the old-style conventional type. The second is about the consequences of quantitative easing. At $4.23 trillion, more than 5 times the 2007 level, the size of securities holdings raises a series of questions: When will the Federal Reserve’s Open Market Committee (FOMC) start to shrink its balance sheet?  How will they do it? How far will they go?  And, most importantly, what will be the consequences for the stance of monetary policy?

On the first two―when and how―the minutes of the March 14-15, 2017 FOMC meeting provide the answers: later this year, the FOMC expects to instruct the open market operations staff at the New York Fed to stop reinvesting the proceeds from maturing securities. Consistent with the policy normalization principles published in September 2014, there is no hint that they will actively sell securities.

The key uncertainty is how far they will go. At this stage, there is little indication of a consensus on how big or small the balance sheet should be at the end of the process. Even if this uncertainty is clarified, however, any additional impact from balance sheet policy on the stance of policy probably will be limited....

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The case for a higher inflation target gets stronger

For several years, economists and policymakers have been debating the wisdom of raising the inflation target. Today, roughly two-thirds of global GDP is produced in countries that are either de jure or de facto inflation targeters (see our earlier post). In most advanced economies, the target is (close to) 2 percent. Is 2 percent enough?

Advocates of raising the target believe that central banks need greater headroom to use conventional interest rate policy in battling business cycle downturns. More specifically, the case for a higher target is based on a desire to reduce the frequency and duration of zero-policy-rate episodes, avoiding the now well-known problems with unconventional policies (including balance sheet expansions that may prove difficult to reverse) and the limited scope for reducing policy rates below zero.

We have been reticent to endorse a higher inflation target. In our view, the most important counterargument is the enormous investment that central banks have made in making the 2-percent inflation target credible. Yet, several lines of empirical research recently have combined to boost the case for raising the target….

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