Dovish Actions Require Dovish Talk (To Be Effective)
The Federal Open Market Committee (FOMC) has bought a lot of assets and kept interest rates extraordinarily low for the past eight years. Yet, all of this stimulus has accomplished surprisingly little (for example, inflation and inflation expectations remain below target and are expected to do so for years to come). Does that experience mean that we should give up on monetary policy as a useful way to stimulate aggregate demand?
My answer is no. I argue that, over the past seven years, the FOMC's has consistently talked hawkish while acting dovish. This communications approach has weakened the effectiveness of policy choices, probably in a significant way. Future monetary policy stimulus can be considerably more effective if the FOMC is much more transparent about its willingness to support the economy - that is, about its true dovishness.
My starting point is that households and businesses don’t make their decisions about spending based on the current fed funds rate - which, is after all, a one-day interest rate. Rather, spending decisions are based on longer-term yields. Those longer-term yields depend on market participants’ beliefs about how monetary policy will evolve over the next few years. Those beliefs are a product of both FOMC actions and FOMC communications.
In December 2008, the FOMC lowered the fed funds rate target range to 0 to a quarter percent. It did not raise the target range until December 2015, when the unemployment rate had fallen back down to 5%. But - with the benefit of hindsight - a shocking amount of this eight years’ worth of unprecedented stimulus was wasted, because it was largely unanticipated by financial markets. (Full disclosure: I took part in FOMC meetings from November 2009 through October 2015, and it could certainly be argued that I was part of the problem that I describe until September 2012.)
I’ll illustrate my basic point in the most extreme way that I can. In November 2009, the Committee’s statement said that the fed funds rate might be raised after “an extended period” - a term that was generally interpreted to mean “about six months”. Accordingly, as footnote 25 of this speech notes, private forecasters in the Blue Chip survey projected that the unemployment rate would be near 10 percent at the time of the first interest rate increase.
Now, suppose that the FOMC had communicated its true reaction function in November 2009 (or even as late as December 2012): as long as inflation was anticipated to be below 2% over the medium-term, the Committee would not raise the fed funds rate until the unemployment rate had fallen to 5% or below. We can’t know the impact of such communication with certainty. But most macroeconomic models would predict that this kind of statement would have put significant upward pressure on employment and prices. In other words: the models predict that if the FOMC had been willing to communicate its true willingness to support the economy, the Committee would have been able to (safely) raise rates much sooner.
I want to be clear: my point in this post is not to express regrets or recrimination over past “mistakes”. (It would have been good in 2009 to know what we know now, but we didn’t.) And my point is not that monetary policy is some kind of panacea. In the presence of a lower bound on nominal interest rates, expansionist fiscal policy would have been helpful in the past (and could be now too).
My point is this: we shouldn’t make judgements about the efficacy of future monetary policy stimulus based on the experience from the past seven years. Unfortunately, much of the potential impact of that lengthy stimulus campaign was vitiated by the FOMC’s generally hawkish communications.
In my view, the FOMC can deliver useful impetus to aggregate demand with its remaining tools. But it needs to communicate ahead of time about its true willingness and ability to support the economy. Without that prior communication, later attempts at stimulus are likely to prove in vain - and the Fed’s credibility may suffer further damage.
N. Kocherlakota
Rochester, NY, February 4, 2016
Please address media enquiries and non-academic speaking requests to Monique Patenaude (monique.patenaude@rochester.edu and 585-276-3693).