Question

Whats the potential for the Federal Reserve’s monetary policies to impact capital markets using specific examples. For example, how can the Federal Reserve “make waves” in capital markets through their communications or lack thereof?

Answer 1

Fortunately, the Fed’s commitment to price stability has indeed become far more credible since the 1970s, so I can illustrate this point based on some recent experience. In 2001, the Fed was able to cut rates aggressively in response to the recession, confident that inflation expectations would remain low. Similarly, over the past two years, wages, core inflation, and long-run inflation expectations have remained well contained despite a dramatic increase in energy prices. With inflation expectations under control, we have avoided a rehash of the 1970s and the need to rein in inflation by engineering a severe recession.

This enhanced transparency complements the systematic approach because it, too, helps the markets anticipate the Fed’s response to economic developments. Recent research highlights the ways in which central bank communication can improve the public’s ability to predict policy actions, and how this improvement can enhance the effectiveness of policy at stabilizing the economy.4The key insight of this research is that the central bank has useful knowledge about the likely direction of the economy and monetary policy that the public does not have. Conveying this information to the public better aligns private and central bank expectations about policy and the economy. And this appears to be working in practice: financial markets have become much better at forecasting the future path of monetary policy than they were up to the late 1980s, and are more certain of their forecast ex ante, as measured by implied volatilities from options contracts.5

Enhanced transparency is particularly valuable when policy has to deviate from its normal, systematic approach. A good illustration comes from 2003, when inflation fell below a comfortable level and there was a threat of outright deflation. In post-FOMC meeting statements issued that year, the FOMC referred to “…an unwelcome fall in inflation…” and worried about “…the risk of inflation becoming undesirably low…” Consistent with the findings of economic research, it made sense for the FOMC to take a more accommodative stance than otherwise would be expected until this threat had passed.6 For this policy strategy to work, it required that the public understand it and correctly foresee that policy would remain accommodative for some time. Again, it is the public’s expectation of future actions, not just the current setting of the fed funds rate, that matters for bond rates, inflation expectations, and other economic variables. Therefore, the FOMC statement at that time said, “In these circumstances, the Committee believes that policy accommodation can be maintained for a considerable period.” This forward-looking language itself seems to have helped keep long-term interest rates low, which added stimulus to the economy and helped avoid deflation.

But, despite the many steps that we have made on communication and transparency, other central banks have gone further than the Fed. Indeed, a growing number of “inflation targeting” central banks explicitly state a numerical objective for the inflation rate and provide reports detailing their economic forecasts.7 There has been a great deal of discussion of whether the Federal Reserve should likewise take further steps towards more open communication, including publicly announcing a specific, numerical inflation objective. I will spend the remainder of my remarks addressing this question, looking first to the results from theoretical and empirical research on the effects of such communication.

Another important reason to provide clear guidance to the public regarding the long-run inflation objective is that doing so may help us avoid deflation and reduce the costs of its occurrence.

We have long known that inflation can be too high, but the recent experience of Japan has reminded us that inflation can be too low as well. We know from history that such an outcome can be extremely damaging to the economy. Perhaps the most unsettling aspect of the experience of Japan over the past decade is how difficult it can be to extract oneself from deflation. An explicit numerical long-run inflation objective may help anchor inflation expectations at a low positive number and avoid a potentially devastating deflationary spiral.

Surveys of long-run inflation expectations have been remarkably stable in both the United States and in inflation-targeting countries over the past ten years. Indeed, based on the evidence from survey data, it’s hard to argue that inflation expectations are not pretty well anchored already.10 An extreme example is provided by the Survey of Professional Forecasters; its median forecast of inflation over the next ten years has barely budged from 2.5% over the past six years, despite large fluctuations in energy prices and other disturbances.

My personal view is that the steps that we have already taken toward greater transparency have been a good thing, and that we should think seriously about venturing further along this path. As Mae West famously said, “Too much of a good thing can be wonderful.” More seriously, although it is possible to carry transparency too far—I would not, for example, want live television coverage of FOMC meetings—I support the idea of a quantitative objective for price stability. I believe that it enhances both Fed transparency and accountability and that it offers important benefits, as I have discussed. In particular, it could help to anchor the public’s long-term inflation expectations from being pushed too far up or down, and thus help avoid both destabilizing inflation scares and deflations; a credible inflation objective could thereby enhance the flexibility of monetary policy to respond to the real effects of adverse shocks.

Indeed, articulating an explicit numerical long-run inflation objective may not be such a big step as some people imagine. Many people have interpreted the FOMC statements in 2003 that I mentioned before as signaling a lower bound for the amount of inflation the FOMC will accept and statements in other years placing an upper bound on acceptable inflation. In addition, several FOMC members have already publicly referred to their comfort zones for inflation and these have been repeated by the press and market analysts. Therefore, such a declaration may serve to solidify and clarify what people already believe to be true.

In my view, the choice of a specific inflation objective should depend, in part, on an evaluation of the costs and benefits of very low inflation. The inflation objective should contain a buffer sufficient to make sure that the lower bound on the nominal interest rate does not interfere with the ability of monetary policy to stabilize the economy and that downward nominal wage rigidity does not interfere with overall labor market performance. Factors such as the magnitude of the neutral real funds rate, the degree of macroeconomic volatility, and the pace of productivity growth, are relevant in assessing the size of the needed buffer. Estimates of the extent of measurement bias in the relevant inflation indices must also figure into the choice of the numerical objective.13

Of course, we do attempt to gauge the level of maximum sustainable employment in analyzing the economy and evaluating policy choices. However, the two pieces of this puzzle, the natural rate of unemployment and trend labor force participation, change over time in unpredictable ways and are measured with considerable error. In the spirit of clearer communication, I think it

would be worthwhile to communicate more fully to the public our analysis and views on the economic outlook and estimates of sustainable employment, unemployment, and output. But, raising these estimates to the level of a formal explicit numerical long-run unemployment objective would be misguided and confusing, and could endanger our hard-won credibility.

In addition to announcing a numerical price stability objective, I believe the Fed should continue to enhance its communications regarding the economic outlook and perspectives on monetary policy. Other central banks have adopted a wide range of communications practices aimed at improving both transparency and accountability. We should carefully study whether any of these might be suitable for the Federal Reserve to adopt. Although policymakers may not see the future perfectly, we do know what we are thinking about in terms of policy, and we should convey that information to the public as best we can.

In summary, the Fed has made significant progress in building credibility over the past two decades by following systematic and appropriate monetary policy and gradually increasing the quality of our communication and transparency. I think it makes sense to take this transparency at least one step further by articulating a numerical price stability objective. I recognize that there are potential costs to doing so, but to my mind, they are outweighed by the benefits. Such a step could further enhance the credibility of the Fed and improve the effectiveness of monetary policy not only for controlling inflation but also for stabilizing employment and output