SEP

Improving U.S. Monetary Policy Communications

Tomorrow, June 4, we will present our paper, Improving U.S. Monetary Policy Communications, as part of the Federal Reserve’s review of its monetary policy strategy, tools, and communications practices. This post summarizes our methodology, analysis and recommendations.

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Since the mid-1990s, the U.S. economy has been reaping the benefits of a credible commitment to price stability, including a communications framework that reinforces that commitment. Over the same period, both the level and uncertainty of inflation have declined (see here).  It is against this backdrop that we look for further enhancements in the Federal Open Market Committee’s (FOMC) communications framework.

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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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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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