Every month, The Big Question video series brings together a panel of Chicago Booth faculty for an in-depth discussion. This is an edited excerpt from April’s episode, in which Eugene F. Fama, Robert R. McCormick Distinguished Service Professor of Finance, Anil K Kashyap, Edward Eagle Brown Professor of Economics and Finance, and Randall S. Kroszner, Norman R. Bobins Professor of Economics, analyzed the effectiveness of central-bank communications. The discussion was hosted by Hal Weitzman, Booth’s executive director for intellectual capital.
How should we think about forward guidance? Is it just a way for central bankers to tell people what they’re thinking, or is it actually a form of intervention in itself?
Kroszner: There are a couple of different purposes. It can provide more clarity on policymakers’ thinking and how they’re going to deal with data that comes in. So, in principle, it can help reduce uncertainty. That would be the best outcome of greater transparency. In addition, it potentially can affect interest rates down the line. Rather than just affect short rates today, which is traditionally what central banks did, forward guidance can affect rates today, tomorrow, next year, and maybe even two or three years down the line. If you look at the market reactions to the Fed’s statements, typically the futures markets moved in line with where the Fed wanted them to move.
Do central banks really control longer-term interest rates?
Fama: It’s pretty clear they don’t control longer-term rates, and it’s not even clear they have much effect on the short rate. If you look at the response of interest rates to changes in the target Fed funds rate, 13%–17% of the response is to the Fed’s announcement, and 83% is just the Fed following open-market rates. The actual response that would have to be put in place to bring about a reasonably large increase in rates is so enormous, it’s out of the range of the Fed. The last five years have been a good experiment. The Fed dumped $3 trillion-worth of short-term debt on the market, and the short-term rate didn’t move at all. It should have gone up. There’s lots of ambiguity about the effect that quantitative easing’s had on the long rate. If you look at the term structure, the difference between the short and the long rates is just about the historical average.
Kroszner: When the Fed first introduced forward guidance to a specific date, the Fed funds–futures market really moved, pretty much directly to that
date. That would suggest that there is some sort of market response.
Fama: When you look at the response of the Fed funds rate itself, most of it is to the level of existing rates. Then you have to look long afterward. There might be a particular response on a given day, but does it dissolve in the next week or so, or does it really
Kroszner: I think it generally stays. When they first introduced a specific date, mid-2013, which was about two years hence, you really did see a move, and it stayed there for quite some time.
Kashyap: Chairman Yellen, at her first press conference, perhaps regrettably said, “I think we can start raising rates six months after we end tapering,” and the markets saw that as news. There’s been good research saying that actions speak louder than words. So forward guidance for a while could reduce uncertainty. But, at some point, you have to back it up. People want to know: “Are you really telling us you’ve changed your preferences in the way you’re going to respond to incoming data, or are you trying to clarify?” And it’s getting harder and harder to keep saying, “We’re just clarifying,” because if the economy is improving, normally they would let rates start rising.
Some have said that forward guidance is a weak version of a rule. Should we, instead, have a rule?
Kashyap: If you wanted to have a rule, you’d live with it in both directions. In forward guidance, we’ve had the easy part where you say we’re going to keep things low, and we haven’t really seen what happens when you try to get out. If you had a rule, maybe it would say that rates should stay low right now; but, at some point, it would be clear there would be a liftoff, and you wouldn’t be fighting it. Over the coming months, they’re going to have to decide: Are we really going to fight the perception that the data are improved and that rates should start rising? I don’t think talking will keep working.
Kroszner: There are broad guideposts out there, but economic circumstances change. The intentions may be the same, but you need to talk about the economy differently. For example, the Fed has now stopped talking about a 6.5% unemployment threshold, partly because the unemployment rate came down for the wrong reasons. There are fewer people in the labor force—that is, fewer people working and fewer people looking for jobs. It’s natural in those changed circumstances to say, “We haven’t changed our intentions, but we have to change the way we talk about it.” People get confused about forward guidance when they think it’s about the words. It’s not about the words; it’s about the intentions and it’s a way to filter the data. It can be helpful to use these guideposts, but the Fed had always said it was also looking at broader labor-market indicators, and if this is not a good labor-market indicator, it would look at something else.
Kashyap: Most bond-market traders have attention deficit disorder, and they view 6.5% as a promise. It’s very hard for the Fed to give these nuanced signals. It’s almost too subtle by half.
What has this done to the credibility of the Fed?
Fama: I didn’t think they had any credibility to begin with. If they wanted rates to rise to 1%, how many trillion dollars’ worth of buying would they have had to do as people flooded them with assets that they wanted to exchange for reserves? That number could be $10 trillion or bigger. There’s always this conundrum that amuses me: every central banker controls interest rates, and they all agree they’re working in an open international bond market. Those two things are inconsistent.
Kroszner: The language has changed over the past five years, but I don’t think you’ve seen an explosion of uncertainty or significant market dislocation when these changes have occurred, because it’s just a way of trying to revise the broader framework to convey its intentions or how to filter data. It’s not about the particulars of the words; it’s about trying to convey broadly what the Fed is thinking and how it’s going to react.
Kashyap: The statement they release after every meeting is getting longer and longer. That’s the best indicator that we’re slipping into uncharted territory. We saw last summer the “taper tantrum,” where the Fed hinted that maybe they were starting to get out, and you saw a big risk-off event in a lot of markets. Until we see somebody get out of all of this and see that the interest rates don’t shoot back up and essentially undo all of the pulling forward of stimulus that they’ve said they’ve accomplished, we’re not going to be able to give a grade. The risk in getting out is they leave people confused. Are we still committed to a 2% inflation objective? Do we think we can permanently try to influence the labor market? They have a long record, pretty good outcomes, and now we say, “OK. Everything is back on the table.” That’s the main risk.
Kroszner: But precisely because we’re in this uncharted territory, we need a little bit more guidance. You just can’t say, “This is what the Fed always did for the last 30 years.” We’ve had five years of zero interest rates and trillions of dollars of excess reserves, so this is a time where you need a little bit more language. I think that it’s appropriate that in a time that’s uncharted, you need to give a little more guidance. If it’s just business as usual, and the usual way that you get out, then you probably don’t need as much guidance.
Fama: The Fed hasn’t really faced the issue of trying to give forward guidance when inflation and unemployment are both a problem. They’ve been lucky about inflation, and unemployment’s been the only deal they have to look at. What happens when you have to trade off these two things? My guess is unemployment wins all the time.
Is forward guidance with us forever?
Kroszner: When things are smoother and more like historical experience, you don’t need as much, so the intentions speak from historical experience rather than from the new words. It will be interesting to see how the exit will be, both in terms of normalizing interest rates and normalizing the statement to make it shorter.
Kashyap: As soon as the economy goes into a growth phase where they can imagine raising interest rates, they’re going to want to run away from this. Having all these situations where everybody’s hanging on exactly what you’re saying about something two-and-a-half years off, or you’re still trying to say, “but it depends,” is just a bad place to be. The sooner they can get out of that, the sooner they will.