Odyssean forward guidance in monetary policy: a primer.
Campbell, Jeffrey R.
Introduction and summary
The Federal Open Market Committee's (FOMC) monetary policy
statement from its September 2013 meeting reads in part:
In particular, the Committee decided to keep
the target range for the federal funds rate at 0 to
1/4 percent and currently anticipates that this exceptionally
low range for the federal funds rate
will be appropriate at least as long as the unemployment
rate remains above 6-1/2 percent, inflation
between one and two years ahead is projected
to be no more than a half percentage point above
the Committee's 2 percent longer-run goal, and
longer-term inflation expectations continue to be
well anchored. (1)
This extended reference to the conditions determining the
FOMC's future interest rate decisions is an example of forward
guidance.
Although participants in FOMC meetings have long used speeches and
congressional testimony to discuss the Fed's possible responses to
economic developments, the Committee has only issued formal and regular
forward guidance since February 2000, when it began to include in its
statement a "balance of risks." The first one read as follows:
"Against the background of its long-run goals of price stability
and sustainable economic growth and of the information currently
available, the Committee believes the risks are weighted mainly toward
conditions that may generate heightened inflation pressures in the
foreseeable future." (2) Less than two years later, the
Committee's August 21,2001, statement noted that "... the
risks are weighted mainly toward conditions that may generate economic
weakness in the foreseeable future." (3)
Between the FOMC's first statement of risks and the financial
crisis that began in August 2007 and intensified in September 2008, the
Fed experimented with making its internal decision-making process more
transparent and therefore more forecastable. In this, they followed
several foreign central banks that had already adopted explicit
inflation targets. (See Bemanke and Woodford, 2005, for a review of
inflation targeting and its implementation outside the United States.)
The financial crisis dramatically accelerated the transition to greater
openness, and the FOMC's forward guidance became more elaborate and
detailed. After lowering the federal funds rate from 5.25 percent in
early August 2007 to 0-25 basis points in mid-December 2008, the
Committee's statement read: "In particular, the Committee
anticipates that weak economic conditions are likely to warrant
exceptionally low levels of the federal funds rate for some time."
(4) "Extended period" replaced "some time" in March
2009, adding specificity. This phrase remained in the statement until
the August 2011 meeting, when it was replaced with the even more
specific "at least through mid-2013." The January 2012
statement pushed this date back to "late 2014."
By this point, these statements had become known as calendar-based
forward guidance. Campbell et al. (2012) discuss the confusion this
language had engendered among the public and market participants as of
early 2012. Was "late 2014" a forecast that the economy would
remain weak until then or a reassurance that the Committee would keep
interest rates low through that date regardless of economic
developments? The Committee's September 2012 statement somewhat
clarified this by stating that the Committee expects "that a highly
accommodative stance of monetary policy will remain appropriate for a
considerable time after the economic recovery strengthens." (5)
Also, in that statement, "late 2014" became
"mid-2015." In its December 12,2012, statement, the FOMC
changed the nature of its forward guidance to reduce confusion by
explicitly tying increases in the federal funds rate to unemployment and
inflation outcomes, using language nearly identical to that from the
September 2013 meeting quoted previously. (6)
It might seem paradoxical that at a time when the FOMC has done so
little with its policy interest rate, it has talked so much about its
plans. Even in normal times, a policymaker promising particular future
actions constrains her future behavior and concomitantly loses
flexibility. However, such forward guidance (sometimes called
"open-mouth operations") can substantially improve current
economic performance when households' and businesses' current
decisions depend on their expectations of future macroeconomic outcomes.
If the FOMC's assurances that rates will remain low raise private
individuals' expectations for future inflation and growth, then
they will wish to consume more today, thereby lifting current aggregate
demand and closing the output gap (the gap between actual and potential
economic output). Although this benefit might indeed come at the cost of
future flexibility, poor enough current macroeconomic performance might
merit this sacrifice. When the zero lower bound (ZLB) on interest rates
makes further conventional accommodation infeasible, the exchange of
future flexibility for current macroeconomic performance becomes
especially attractive.
Future policy actions only have impact if credible
In general, statements of future policy intentions have no impact
(benign or otherwise) when the public does not find them credible. This
problem is particularly acute for a central bank, because a central bank
seeking to improve households' current and future welfare will be
tempted to renege on past interest rate promises. The interest rate that
is currently optimal might not be consistent with promises that improved
past economic performance, and breaking those promises now does nothing
to the past and improves present and future outcomes. If the public
anticipates that monetary policymakers will apply such logic in the
future, then promises of low future interest rates will not be believed
and, therefore, will have no beneficial effect in the present. This
conundrum is one example of the time-consistency problem, for the
discovery of which Kydland and Prescott (1977) received a Nobel Prize in
2004. Since this kind of beneficial forward guidance requires the
policymaker to keep past promises, even when sorely tempted to do what
seems best at the moment, Campbell et al. (2012) label this Odyssean
forward guidance. Like Odysseus bound to the mast of his ship, a
monetary policymaker must forswear the siren call of the moment and
stick to plans laid in the past. Odysseus achieved this with ropes for
himself and earwax for his crew. Research into the analogous tools
available to monetary policymakers is ongoing.
Of course, not every pronouncement by a monetary policymaker is a
promise. Some statements merely forecast the evolution of the private
economy. Campbell et al. (2012) label such forecast-based statements
Delphic forward guidance. Like the pronouncements from the oracle of
Delphi, they forecast but do not promise. While Delphic pronouncements
undoubtedly contribute positively to the execution of monetary policy, 1
ignore them in this article to develop instead a primer on the economic
theory of Odyssean forward guidance.
This primer's basic framework is the minimal New Keynesian
model, in which the central bank chooses the interest rate to achieve
the best feasible trade-off of output and inflation. First, I discuss
this model, develop key results, and present some simple calculations of
optimal monetary policy paths that start with the economy at the zero
lower bound. Although I review the model's two linear equations,
one inequality, and quadratic social welfare function in the text, I
present the main results in figures for simplicity. I conclude the
primer with a brief discussion of current monetary policy examined
through the lens of this theory.
Forward guidance in the New Keynesian model
Effective forward guidance requires the central bank to communicate
its intentions and the public to believe that the bank is committed to
their execution. The potential contribution of communication and
commitment to improved monetary policy can be most easily appreciated in
the canonical New Keynesian model that summarizes the behavior of
producers, households, and a central bank with a Phillips curve, an
intertemporal substitution (IS) curve, the zero lower bound on interest
rates, and a central bank loss function.
1) [[pi].sub.t] = [kappa][[??].sub.t] + [beta][[pi].sub.t+1] +
[m.sub.t],
2) [[??].sub.t] = -1/[sigma]([i.sub.t] - [[pi].sub.t+1] -
[r.sup.n.sub.t]) + [[??].sub.t+1],
3) [i.sub.t] [greater than or equal to] 0,
4) L = [[infinity].summation over(t=0)][[beta].sup.t] 1/2
([[pi].sup.2.sub.t] + [lambda][[??].sup.2.sub.t]).
More advanced versions of this model incorporate uncertainty about
future macroeconomic outcomes. For the sake of simplicity, this primer
abstracts from this complication and presumes that, conditional on the
central bank's policy choices, future macroeconomic outcomes can be
calculated with certainty.
In equation 1, [[pi].sub.t] is the rate of price inflation in year
t and [[??].sub.t] is that year's output gap, defined to be the
percentage deviation of actual output from its potential. (In New
Keynesian models, producers can only adjust their dollar-denominated
prices infrequently. It is this sluggish price adjustment that drives
output away from its potential.) The influence of future inflation on
its current level reflects the forward-looking behavior of producers
choosing their prices. Woodford (2003) and Gali (2008) present
derivations of equation 1 from the optimal pricing decisions of
producers who can only adjust their nominal prices infrequently. In
those derivations, the coefficient [beta] is the discount factor
producers apply to their future profits. The Phillips curve's
slope, [kappa], is an increasing function of the frequency of price
adjustment. Perfectly flexible prices lead to a vertical Phillips curve,
so that [kappa] = [infinity], while perfectly rigid prices set [kappa]
to zero. The output gap influences producers' prices because it
reflects their current marginal costs of production. The markup shock
finishes the right-hand side of equation 1. It evolves exogenously and
embodies changes in producers' prices that are unrelated to changes
in their marginal costs. For example, an exogenous decline in
competitive price pressures due to leniency in antitrust enforcement or
innovations in market segmentation can show up as a positive [m.sub.t].
Because the Phillips curve reflects producer decisions, it is often
labeled the economy's "supply side."
Equation 2 reflects households' split of current income
between saving and consumption. The model's households can invest
in a one-year risk-free bond at the nominal interest rate [i.sub.t].
This choice yields the inflation-adjusted return [i.sub.t] -
[[pi].sub.t+1]. Individual households can buy and sell this bond in
unlimited amounts, but I keep the model simple by assuming that it is in
zero aggregate supply. The economy has no capital or other means for
real wealth accumulation, so total consumption must equal total income.
Therefore, the output gap [[??].sub.t] also equals the percentage
deviation of actual consumption expenditures from their potential. From
this perspective, the IS curve relates the current consumption gap to
the interest rate and the consumption gap in the next period. The
parameter a is called the inverse absolute intertemporal elasticity of
substitution. It is typically positive, so that increases in the
interest rate induce households to increase saving and delay
consumption. On the other hand, high future consumption reduces the
incentive to save and increases current consumption. The final term
requiring explanation in equation 2 is [r.sup.n.sub.t], the natural rate
of interest. This term is an exogenously evolving sequence that embodies
changes in households' relative valuations of current and future
consumption. If [r.sup.n.sub.t] drops but [i.sub.t] - [[pi].sub.t+1]
remains the same, then the household wishes to reduce current
expenditures to save more now and, thereby, allow more consumption in
the future. In this sense, a relatively low value of [r.sup.n.sub.t]
indicates that the household is unusually patient. However, this
household-based interpretation of [r.sup.n.sub.t] is probably at best a
convenient fiction. In practice, many economists interpret low measured
levels of [r.sup.n.sub.t] since the onset of the financial crisis as
arising from the crisis itself and the resulting desire of both
households and financial firms to remove both debt and risk from their
balance sheets. (7) The IS curve can be thought of as the economy's
"demand side."
The ZLB in equation 3 seems natural, because negative nominal
interest rates are rarely, if ever, observed. It also has empirical
appeal, because investors can move their portfolios into cash (which has
a zero interest rate by construction) rather than holding bonds with
negative rates. (8) In this article, I follow Eggertsson and Woodford
(2003) and Christiano, Eichenbaum, and Rebelo (2011) and make the zero
lower bound relevant with a large negative value of the natural rate of
interest.
The central bank controls the nominal rate of interest; and its
choices influence inflation and the output gap through the Phillips and
IS curves. The Federal Reserve Act mandates that the FOMC use this
influence "to promote effectively the goals of maximum employment,
stable prices, and moderate long-term interest rates."
The model's central bank fulfills such a mandate by choosing
interest rates to minimize the loss function in equation 4. It penalizes
current and future deviations from zero of inflation and of the output
gap. (9) The coefficient X gives the central bank the relative weight on
its output stabilization objective. (10) The central bank uses the
firms' discount factor, [beta], to evaluate the tradeoff between
current and future losses. Woodford (2003) and Gali (2008) both give
derivations of this loss function as quadratic approximations of
households' welfare. Under this interpretation, both inflation and
deflation distort the relative prices of goods; and positive and
negative output gaps move households away from their desired allocation
of time between labor and leisure.
The central bank's choice of [i.sub.t] directly influences the
current output gap through the IS curve and, thereby, indirectly
influences inflation through the Phillips curve. However, this
traditional static view of monetary policy is incomplete because
producers and consumers base their decisions not merely on current
policy, but also on their expectations for future inflation and output.
It is this channel that makes forward guidance potentially useful.
Discretionary monetary policy
One cannot appreciate the value of commitment without understanding
outcomes in its absence, so I begin with a review of monetary policy
under discretion. By discretion, I mean that the central bank can set
the current interest rate but has no direct influence over future rates
until the future itself arises. As discussed earlier, a discretionary
central bank takes no account of how expectations of its current actions
influenced past behavior because those bygones are just that, bygones.
There is little room for central bank communication to alter
macroeconomic outcomes, because the only credible forward guidance
simply describes what the central bank will find to be optimal when the
time comes. Campbell et al. (2012) place such statements in the category
of Delphic forward guidance.
Since future interest rates determine future inflation rates and
output gaps, the only terms in the central bank's loss function
under its current control give the current loss, 1/2 ([[pi].sup.2.sub.0]
+ [lambda][[??].sup.2.sub.0]). The discretionary central bank's
optimal interest rate minimizes this current loss by taking as given
[[??].sub.1], [[pi].sub.1], [m.sub.0], and [r.sup.n.sub.0].
The divine coincidence
I begin consideration of this choice with the very special case in
which [m.sub.t] = 0 and [r.sup.n.sub.t] [greater than or equal to] 0
always. If fortuitously both [[??].sub.1] and [[pi].sub.1] also equal
zero, then the IS curve allows the central bank to achieve a zero output
gap by simply setting [i.sub.t] to [r.sup.n.sub.t]. Since
[beta][[pi].sub.1], + [m.sub.0] = 0, the Phillips curve translates a
zero output gap into zero current inflation. That is, if future
inflation and the cost-push shock both equal zero and the natural rate
of interest is positive, then the central bank can achieve the minimum
possible loss by completely stabilizing both the output gap and
inflation. Blanchard and Gali (2010) have referred to a similar result
in a more complicated model as a "divine coincidence." The
Phillips curve, which determines which inflation and output gap
combinations are feasible, passes through the best possible such
combination, no inflation and no output gap. One might object that this
superior outcome merely reflects the good fortune of inheriting
expectations of price and output stability, but the fact that the
central bank wishes to achieve such stability gives one reason to
believe that it will occur. Indeed, if both [[??].sub.2] and
[[pi].sub.2] equal zero, then the central bank can and will achieve
complete macroeconomic stability in period 1. Continuing in this fashion
yields the following result: If [m.sub.t] = 0 always and [r.sup.n.sub.t]
is never negative, then the interest rate rule [i.sub.t] =
[r.sup.n.sub.t] is feasible and achieves complete macroeconomic
stabilization. To prove the result to yourself, simply note that the
sequences [[??].sub.t] = 0 and [[pi].sub.t] = 0 satisfy both the
Phillips and IS curves if [r.sup.n.sub.t] = [i.sub.t], always.
Furthermore, this interest rate choice minimizes the current loss, so
households and businesses should expect the central bank to follow it.
The output-inflation trade-off
When [beta][[pi].sub.1] + [m.sub.0] differs from zero, the central
bank cannot achieve complete stabilization because the Phillips curve no
longer passes through the origin. In this case, the discretionary
central bank faces a classic output-inflation trade-off. Panel A of
figure 1 illustrates this trade-off with a familiar indifference curve
budget-set diagram. Here, the Phillips curve (in red) plays the role of
the budget constraint. The central bank can choose any inflation-output
gap combination on the curve. Its slope equals k, and it crosses the
vertical axis at [beta][[pi].sub.1] + [m.sub.0]. The family of
indifference curves comes from the central bank's loss function.
Each one gives the inflation-output gap combinations that yield a
constant value for the current loss function. If [lambda] equals one,
each indifference curve is a circle. In general, the curves are
ellipses, but I have drawn only their portions in the northwest
quadrant. The points on an indifference curve that lie inside of another
give a lower total loss. If the central bank were to choose an
inflation-output gap combination with an indifference curve that crosses
the Phillips curve, then it could achieve a lower loss by sliding away
from the closest axis along the Phillips curve. Therefore, the Phillips
curve must be tangent to the best possible point's associated
indifference curve. This is marked in the figure with the red point
labeled "Chosen [[??].sub.0], [[pi].sub.0]." The central bank
tolerates both higher-than-desired inflation and lower-than-desired
output as the best feasible outcome. The exact inflation-output gap
chosen balances the loss from increasing inflation slightly with the
loss from slightly deepening the recession.
[FIGURE 1 OMITTED]
The nominal interest rate is notable in this standard analysis of
the output gap-inflation trade-off only by its absence. The Phillips
curve alone determines the output-inflation trade-off. So long as the
desired output gap is not below what can be achieved by setting
[i.sub.0] to zero, the IS curve merely determines the nominal interest
rate that guides the private sector to the central bank's favored
outcome. The IS curve becomes more relevant to the problem when the ZLB
on [i.sub.0] constrains the central bank. To see how, isolate [i.sub.0]
on the left-hand side of equation 2, substitute the resulting right-hand
side into the ZLB in equation 3, and arrange the result to put
[[??].sub.0] on the lower side of the inequality,
[[??].sub.0] [less than or equal to] [[??].sub.1] +
[[r.sup.n.sub.t] + [[pi].sub.1]] / [sigma].
That is, the ZLB and IS curve together put an upper bound on the
output gap. When this upper bound is a negative number, it can be
interpreted as a lower bound on the size of a recession. If this lower
bound is high enough, then conventional interest rate policy cannot
mitigate a recession. Panel B of figure 1 depicts the central
bank's choice in this case. The dashed vertical line indicates the
location of the upper bound on [[??].sub.0]. Without the ZLB, optimal
monetary policy would guide the economy to the tangent point marked
"[i.sub.0] < 0." The ZLB moves the actual outcome southwest
along the Phillips curve to the point marked "[i.sub.0] = 0,"
where the Phillips curve intersects the vertical line. Since the central
bank's indifference curve is steeper than the Phillips curve, it
would like to reduce the current output gap at the expense of higher
inflation. However, the ZLB prevents it from doing so. This illustrates
how conventional monetary policy at the ZLB is "too tight."
Monetary policy with commitment and communication
Both the Phillips curve and IS curve are forward looking, so each
of them can serve as a channel for forward guidance to influence current
macroeconomic outcomes. Panels C and D of figure 1 illuminate these
channels. Suppose that the central bank could credibly influence private
expectations about inflation in year one. Lowering [[pi].sub.1],
directly shifts the Phillips curve down and, thereby, expands the set of
possible current output gap-inflation outcomes. Panel C illustrates this
situation, in which forward guidance moves inflation and the output gap
toward their desired levels. Economically, a credible promise of future
disinflation lowers producers' current desired prices and, thereby,
allows the central bank to achieve a given level of current inflation
with a smaller output gap. Of course, the promised deflation and its
accompanying output gap also cost the central bank. The size of the cost
depends on the initial values for [[pi].sub.1], and [[??].sub.1]. If a
substantial deflationary recession was already anticipated, then
fighting current inflation with forward guidance might be too costly. On
the other hand, if both [[pi].sub.1] and [[??].sub.1] begin at zero,
then slight changes to them have very, very small costs.
Since the IS curve is irrelevant for discretionary monetary policy
away from the ZLB, it should be no surprise that forward guidance works
through the IS curve only when the ZLB constrains policy. Panel D of
figure 1 shows how forward guidance can influence outcomes in this case.
The upper bound for [[??].sub.0] derived from the IS curve and the ZLB
constraint increases in both [[pi].sub.1] and [[??].sub.1], so this
lower bound shifts to the right if the central bank's promises of
low future interest rates increase expectations of inflation, the output
gap, or both in year one.
If this were the end of the story, the forward guidance would slide
the inflation-output gap outcome along a fixed Phillips curve. However,
the increase in promised inflation also shifts the Phillips curve up. As
drawn, the cost of the additional current inflation is less than the
benefit from the reduced output gap. (The indifference curve running
through the point marked "End" is interior to the one passing
through "Start.") Just as in the case displayed in figure 1,
whether this improvement in current outcomes is worth the required
change in 7t, and y, will depend on their initial levels. If the central
bank inherits expectations of future macroeconomic stability, then the
cost of forward guidance is small.
Optimal monetary policy as a path
The same constraints that limit the central bank's actions in
year zero also apply to future years, so this discussion of forward
guidance would be incomplete if it stopped at figure 1. To bring future
years' Phillips curves and IS curves into the picture, consider the
problem of a central bank in year zero choosing values for [[pi].sub.t],
[[??].sub.t], and [i.sub.t] from year zero into the infinite future. The
central bank chooses these to minimize the loss function in equation 4,
but the chosen sequences must satisfy the Phillips curve, IS curve, and
ZLB in equations 1, 2, and 3 for all years. This dynamic formulation of
the monetary policy problem is necessary for the full consideration of
forward guidance, because it allows the central bank to quantitatively
compare the current gains from forward guidance with the future costs of
following through on promises made. Because Ramsey (1927) first
conceived of economic policy as choosing a vector of economic outcomes
to achieve the lowest social cost possible subject to the constraints
imposed by private decision-making, economists call this a Ramsey
problem and its policy prescription a Ramsey solution. In this
particular context, the central bank's loss function determines the
social cost of specific sequences for the output gap and inflation, and
the constraints imposed by private decision-making are the Phillips
curve, IS curve, and ZLB.
The Ramsey outcome can be best appreciated by studying an example
calculated from a particular parameter configuration. To impose a
neutral interest rate of 4 percent, the example set [beta] = exp
(-0.04). Evans (2011) discusses the numerical values for [lambda]
consistent with the Fed's dual mandate of promoting maximum
employment with stable prices, and the example uses his preferred value
[lambda] = 0.25. The absolute intertemporal elasticity of substitution a
equals one; so a 1 percent reduction in the natural interest rate lowers
the output gap's upper bound by 1 percent.
Figure 2 shows the sequence of output gaps and inflation rates that
minimize the central bank's loss function with these parameters
when a temporarily negative natural rate of interest drives the economy
to the ZLB in year zero. That is, [r.sup.n.sub.0] = -0.01 and
[r.sup.n.sub.t] = 0.04 for t [greater than or equal to] 1. (The markup
shock that placed the analysis of figure 1 into the northwest quadrant
equals zero here.) The figure reports results for two values of [kappa],
0.04 and 1.00. The smaller "flat" value of [kappa] is of the
magnitude favored by Eggertsson and Woodford (2003). It requires a 20
percent decrease in the output gap to lower inflation by 1 percent. One
might judge such a large sacrifice ratio to be unrealistic, because
actual disinflations (such as that engineered by Paul Volcker in the
early 1980s) have not generated such large output declines. The
relatively larger value for [kappa] addresses this possibility.
[FIGURE 2 OMITTED]
In figure 2, the black arrows pointing to the vertical axes
indicate each variable's value in year zero without forward
guidance. (In all future years, the discretionary values of
[[pi].sub.t], [[??].sub.t], and [i.sub.t] are zero, zero, and 0.04,
respectively.) By construction, discretionary monetary policy can do
nothing to mitigate the effects of hitting the ZLB. The negative 1
percent natural interest rate drives [[??].sub.0] to -1 percent,
irrespective of the Phillips curve's specification. The Phillips
curve's slope determines the size of the associated disinflation.
With the flat Phillips curve, this equals only -4 basis points, but with
the steep Phillips curve, inflation falls 1 full percentage point.
When the central bank instead employs forward guidance, the decline
in the output gap is substantially reduced, to -47 and -35 basis points
with the flat and steep Phillips curves, respectively. To achieve such
moderation of the initial recession, the central bank engineers a future
inflationary expansion. In year one, the output gap equals 50 and 35
basis points with the flat and steep Phillips curves, respectively. With
the flat Phillips curve, inflation in year one is hardly noticeable, but
it equals 30 basis points with the steep Phillips curve. More noticeable
is the effect of forward guidance on year zero inflation when the
Phillips curve is steep. It rises from -1 percentage point to -7 basis
points. The experiments with both slopes feature very small deviations
from steady state after year one, and they have nearly identical
associated paths for the interest rate. By construction, [i.sub.0] = 0.
The interest rate equals about 3.54 percent in year one and thereafter
stays very close to the natural rate.
These numerical results illustrate two principles emphasized by
Eggertsson and Woodford (2003). First, optimal monetary policy at the
ZLB resembles the prescriptions of price-level targeting (PLT). Under
PLT, the central bank announces targets for a relevant price index, such
as the deflator for consumer expenditures excluding food and energy
goods, for several dates. The central bank then chooses policy in order
to come as close as possible to these targets. If inflation falls short
of its expected value, then the central bank deliberately tolerates a
later overshooting of inflation, which brings the price level closer to
its stated target. Qualitatively, this policy can be seen in the optimal
inflation path with a steep Phillips curve. The deflation of 7 basis
points is followed by an inflation of 30 basis points. Recall that even
if the ZLB does not bind, a central bank facing an output-inflation
trade-off resulting from an inflationary markup shock would like to
promise deflation in the future to move the Phillips curve back toward
the origin. The inflation followed by deflation also resembles the PLT
outcome. Eggertsson and Woodford (2003) provide a more extensive but
similar argument that PLT should always be followed, both at and away
from the ZLB.
The second principle can be seen in the accommodative interest rate
in year one: Optimal forward guidance promises to maintain an
expansionary monetary policy after the conditions that initially
warranted it have passed.
Conclusion
Since economic growth remains below potential, inflation is running
below the FOMC's target of 2 percent, and the ZLB prevents further
conventional monetary accommodation, the FOMC has turned to two
nontraditional monetary policy tools, quantitative easing and forward
guidance. This article has shown how the latter, through "open
mouth operations," can improve current macroeconomic outcomes by
altering current expectations of future inflation and output. In the
Ramsey problem, the central bank's ability to manipulate
expectations is assumed to be perfect. Campbell et al. (2012) review the
considerable evidence that FOMC members did indeed influence private
expectations before the financial crisis, and they expand upon it by
showing that FOMC statements continued to move asset prices in the
post-crisis period. Such influence is undoubtedly helpful for
implementing forward guidance, so it seems reasonable to assume that
FOMC participants have built up enough influence with the public to
credibly commit to forward guidance.
This primer reviewed the theory of such guidance, but the question
of how well the FOMC's current guidance matches that of the theory
remains open. In the simple model I used to solve the Ramsey problem,
the natural interest rate follows a simple predetermined path and there
are no markup shocks. In practice, both the FOMC and the public face
considerable uncertainty about the path of the natural interest rate.
Furthermore, shocks to supply (through the markup shock) and demand
(through the natural interest rate) continue to impact the economy even
though they are more pedestrian than those that caused the financial
crisis. Mimicking the Ramsey solution in such circumstances would
require the FOMC to specify a comprehensive rule for its interest rate
decisions and associated forecasts for inflation and the output gap. In
such a complex world, where the possible sources of future economic
turbulence cannot even be reliably listed (not to mention quantified),
such a complete solution is unrealistic.
What the FOMC has done instead is provide threshold-based guidance.
The Committee expects the current interest rate of approximately zero to
remain appropriate at least as long as the unemployment rate remains
above 6.5 percent and medium-term inflation expectations remain below
2.5 percent. This guidance can be consistent with the
"overshooting" prescription of the Ramsey solution. Of course,
the simple model presented here gives just a qualitative guide to
optimal forward guidance. The more sophisticated model of Eggertsson and
Woodford (2003) differs from it only by randomizing the time at which
the natural rate of interest permanently returns to its long-run value,
so that provides hardly more quantitative guidance for the current
situation. Extending this policy framework to include a more realistic
random evolution of [r.sup.n.sub.t] and ongoing markup shocks is the
subject of current research.
REFERENCES
Bernanke, B. S., and M. Woodford (eds.), 2005, The
Inflation-Targeting Debate, Chicago: University of Chicago Press.
Blanchard, O., and J. Gali, 2010, "Labor markets and monetary
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NOTES
(1) The full press release from the September 18, 2013, FOMC
meeting is available at
www.federalreserve.gov/newsevents/press/monetary/ 20130918a.htm.
(2) See www.federalreserve.gov/boarddocs/press/general/2000/
20000202/default.htm.
(3) See www.federalreserve.gov/boarddocs/press/general/2001/
20010821/default.htm.
(4) See www.federalreserve.gov/newsevents/press/monetary/
20081216b.htm.
(5) See www.federalreserve.gov/newsevents/press/monetary/
20120913a.htm.
(6) See www.federalreserve.gov/newsevents/press/monetary/
20121212a.htm.
(7) Since it corresponds to no specific market interest rate,
r" cannot be directly observed. However, it can be inferred from
observations of actual interest rates and households' consumption
and savings decisions. See Justiniano and Primiceri (2010) for a review
of this procedure.
(8) One might object that the simple model economy at hand has no
cash, only one-period bonds. Woodford (2003) asserts that adding cash to
the model leaves its basic economics unchanged. This article uses the
cashless version of the New Keynesian model to maintain simplicity.
(9) Virtually by definition, bringing the output gap closer to zero
improves social welfare. However, zero inflation is not necessarily the
socially optimal definition of "price stability."
Reifschneider and Williams (2000) discuss this in more detail. For
simplicity, this primer abstracts from this issue by defining
"price stability" with a zero inflation rate.
(10) One might object that the output gap appears in equation 4
rather than an analogously defined employment gap. Since Okun's law
connects these two gaps, the stabilization of the output gap is indeed
consistent with the Fed's dual mandate. See Evans (2011) for a
discussion of this issue.
Jeffrey R Campbell is a senior economist and research advisor in
the Economic Research Department at the Federal Reserve Bank of Chicago
and an external fellow at CentER Tilburg University. The author is
grateful to Marco Bassetlo, Charlie Evans, Jonas Fisher, Alejandro
Justiniano, and Spencer Krone for many stimulating discussions on
forward guidance and to Wouter den Haan, Alejandro Justiniano, and Dick
Porter for helpful editorial feedback. This article is being
concurrently published in Wouter den Haan (ed), 2013, Forward
Guidance--Perspectives from Central Bankers, Scholars and Market
Participants, Centre for Economic Policy Research, VoxEU.org.
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