Forward guidance The non-standard tool on which central bankers are most likely to rely in the next easing cycle is forward guidance, or communication about the expected or intended future path of the policy rate. The Fed used variants of forward guidance in the Greenspan era, for example, in references to keeping rates low for a considerable period"(Federal Open Market Committee 2003). Even earlier, a number of central banks experimented with forward-looking policy commitments, a notable case being the Bank of Japan's zero-interest-rate policy (ZiRP), in which the boj said that it would not lift rates from zero until certain conditions had been met (Bank of Japan, 1999). The prices of longer-term financial assets(including those most closely tied to economic activity, such as corporate bonds, mortgages, and stocks)depend on not only the current setting of the policy rate but on its entire expected future path. Consequently, central bank"open-mouth operations" that influence market expectations of future policies can affect financial conditions today, even if the short-term policy rate is close to its effective lower bound Guthrie and Wright, 2000) Forward guidance comes in a number of forms. A useful distinction is between Delphi and Odyssean forward guidance( Campbell et al., 2012). Delphic guidance is a simple statement of how monetary policymakers see the economy and interest rates as likely to evolve. Delphic guidance is advisory only and makes no promises about future policy. In contrast, Odyssean guidance-the phrase is motivated by Odysseus's decision to tie himself to the mast to be able to resist the calls of the Sirens--is intended to pre-commit the central bank to some(possibly contingent) set of future policies The goals of Delphic and Odyssean guidance are different. Delphic guidance-as for example seen in the Fed's famous dot plot, which shows the interest-rate forecasts of individual FOMC participants--is designed primarily to help the public and market participants understand the committee's outlook, reaction function, and policy plans. More informally central bankers' public remarks about the likely course of the economy and policy are usuall Delphic in intent. Increasingly, central banks are incorporating Delphic guidance into their communication strategy during normal times this development primarily reflects trends to increased transparency by central banks, rather than the emergence of the Zlb as an important
5 Forward guidance The non-standard tool on which central bankers are most likely to rely in the next easing cycle is forward guidance, or communication about the expected or intended future path of the policy rate. The Fed used variants of forward guidance in the Greenspan era, for example, in references to keeping rates low for “a considerable period” (Federal Open Market Committee, 2003). Even earlier, a number of central banks experimented with forward-looking policy commitments, a notable case being the Bank of Japan’s zero-interest-rate policy (ZIRP), in which the BOJ said that it would not lift rates from zero until certain conditions had been met (Bank of Japan, 1999). The prices of longer-term financial assets (including those most closely tied to economic activity, such as corporate bonds, mortgages, and stocks) depend on not only the current setting of the policy rate but on its entire expected future path. Consequently, central bank “open-mouth operations” that influence market expectations of future policies can affect financial conditions today, even if the short-term policy rate is close to its effective lower bound (Guthrie and Wright, 2000). Forward guidance comes in a number of forms. A useful distinction is between Delphic and Odyssean forward guidance (Campbell et al., 2012). Delphic guidance is a simple statement of how monetary policymakers see the economy and interest rates as likely to evolve. Delphic guidance is advisory only and makes no promises about future policy. In contrast, Odyssean guidance—the phrase is motivated by Odysseus’s decision to tie himself to the mast to be able to resist the calls of the Sirens—is intended to pre-commit the central bank to some (possibly contingent) set of future policies. The goals of Delphic and Odyssean guidance are different. Delphic guidance—as for example seen in the Fed’s famous “dot plot,” which shows the interest-rate forecasts of individual FOMC participants—is designed primarily to help the public and market participants understand the committee’s outlook, reaction function, and policy plans. More informally, central bankers’ public remarks about the likely course of the economy and policy are usually Delphic in intent. Increasingly, central banks are incorporating Delphic guidance into their communication strategy during normal times; this development primarily reflects trends to increased transparency by central banks, rather than the emergence of the ZLB as an important
policy constraint. By improving the clarity of the central bank communication, Delphic guidance is intended to increase the predictability of monetary policy and make it more effective Odyssean guidance, in contrast, is most likely to be relevant when the policy rate is at or close to the ZlB, so that the scope for short-term rate cuts is limited. Typically, monetary policymakers use Odyssean guidance to communicate a promise to keep rates lower for longer than implied by their"normal"reaction function. If the promise is credible, then market participants should bid down longer-term yields and bid up asset prices today, effectively adding stimulus despite the ZlB constraint. The key word here is"commitment. "If prior commItment were impossible, for the reasons explored in the time-consistency literature( Kydland and Prescott, 1977), then Odyssean forward guidance could not materially change market expectations and would consequently be useless. In practice, central bank guidance does appear to have significant effects on asset prices(Campbell et al., 2012; Swanson, 2017)and thus, presumably, on the economy. Central bankers concerns for their own reputations and those of their institutions, as well as the tendency of market participants to look for focal points around which expectations can coalesce, appear in practice to provide monetary policymakers some ability to commit to future policy actions The Federal Open Market Committee(FOMC), the Fed's policymaking body, provided regular forward guidance during the recovery from the crisis. Some controversy has arisen about the FOMC's approach. Michael Woodford (2009)and others have argued that the FOMC inappropriately used Delphic rather than Odyssean formulations in its guidance, limiting its enefit. For example, at the same meeting at which the policy rate was cut effectively to zero the december 2008 FOMC statement indicated, ". the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time"(FOMC, 2008 ). By speaking of anticipating" or"expecting " rates to remain low, rather than using stronger language of commitment or intention, Woodford argues, the FOMC created less stimulus than it might have. Indeed, by signaling pessimism about the outlook, the FOMC's guidance(in Woodfords view)might have been counterproductive Woodford is right in principle, and all else equal, a policy committee whose intent is to provide odyssean guidance should try to make its commitments as clear and as nearly ironclad as possible. A real-world complication is that policy committees are not typically unitary actors but may include participants of diverse views, trying to reach compromise in an uncertain
6 policy constraint. By improving the clarity of the central bank communication, Delphic guidance is intended to increase the predictability of monetary policy and make it more effective. Odyssean guidance, in contrast, is most likely to be relevant when the policy rate is at or close to the ZLB, so that the scope for short-term rate cuts is limited. Typically, monetary policymakers use Odyssean guidance to communicate a promise to keep rates lower for longer than implied by their “normal” reaction function. If the promise is credible, then market participants should bid down longer-term yields and bid up asset prices today, effectively adding stimulus despite the ZLB constraint. The key word here is “commitment.” If prior commitment were impossible, for the reasons explored in the time-consistency literature (Kydland and Prescott, 1977), then Odyssean forward guidance could not materially change market expectations and would consequently be useless. In practice, central bank guidance does appear to have significant effects on asset prices (Campbell et al., 2012; Swanson, 2017) and thus, presumably, on the economy. Central bankers’ concerns for their own reputations and those of their institutions, as well as the tendency of market participants to look for focal points around which expectations can coalesce, appear in practice to provide monetary policymakers some ability to commit to future policy actions. The Federal Open Market Committee (FOMC), the Fed’s policymaking body, provided regular forward guidance during the recovery from the crisis. Some controversy has arisen about the FOMC’s approach. Michael Woodford (2009) and others have argued that the FOMC inappropriately used Delphic rather than Odyssean formulations in its guidance, limiting its benefit. For example, at the same meeting at which the policy rate was cut effectively to zero, the December 2008 FOMC statement indicated, “…the Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time” (FOMC, 2008). By speaking of “anticipating” or “expecting” rates to remain low, rather than using stronger language of commitment or intention, Woodford argues, the FOMC created less stimulus than it might have. Indeed, by signaling pessimism about the outlook, the FOMC’s guidance (in Woodford’s view) might have been counterproductive. Woodford is right in principle, and all else equal, a policy committee whose intent is to provide Odyssean guidance should try to make its commitments as clear and as nearly ironclad as possible. A real-world complication is that policy committees are not typically unitary actors, but may include participants of diverse views, trying to reach compromise in an uncertain
environment. Some hedging or ambiguity in the committees official statements may therefore be difficult to avoid. In practice, however, the FOMC s guidance after the crisis-as mediated by the public comments of policymakers-did seem to have Odyssean effects. Notably, the Feds introduction of forward guidance was typically followed by changes in longer-term interest rates, exchange rates, and equity prices consistent with substantial increases in monetary accommodation(Femia et al., 2013; Swanson, 2017) and by reduced sensitivity of near-term rate expectations to economic news(williams, 2014). The increases in equity prices in particular suggested that markets were focused on the FOMC's signal of greater policy patience(the Odyssean aspect)rather than on an indication of greater pessimism delphic). moreover professional forecasters reacted to FOMC guidance by repeatedly marking down the unemployment rate they expected to prevail at the time that the Committee began to lift the funds rate away from zero, implying a perceived shift in the Fed's expected reaction function (Bernanke, 2012; Femia et al., 2013). The apparent success of the FOMC's guidance, developee on the fly, is promising for the future use of verbal interventions. As both central bankers and market participants gain experience with forward guidance, the tool should become increasingly effective Another important distinction is between qualitative guidance("considerable period) and quantitative guidance, for example, describing specific economic conditions that would lead to a change in policy. Over the years, Fed guidance has evolved from qualitative towards quantitative, reflecting the desire to enhance transparency as well as the imperative of adding substantial accommodation during the ZlB period. Economic logic suggests that quantitative guidance will be more effective, because it is both more precise and more verifiable ex post(and thus easier to support by reputational concerns). However, again, a policy committee may not al ways be able to agree on quantitative guidance. It may also be the case that uncertainty about the economic situation favors the relative ambiguity of a qualitative formulation, at least initially Experience suggest though that qualitative guidance, if maintained for a while, often morphs into quantitative guidance, as market participants, legislative committees, and other stakeholders press policymakers to clarify the meaning of key phrases Yet another dimension of forward guidance is time-dependency versus state-dependency The FOMC used both types after the crisis, indicating first that it expected to hold rates low through a certain date, then tying rate increases to thresholds based on the prevailing
7 environment. Some hedging or ambiguity in the committee’s official statements may therefore be difficult to avoid. In practice, however, the FOMC’s guidance after the crisis—as mediated by the public comments of policymakers—did seem to have Odyssean effects. Notably, the Fed’s introduction of forward guidance was typically followed by changes in longer-term interest rates, exchange rates, and equity prices consistent with substantial increases in monetary accommodation (Femia et al., 2013; Swanson, 2017) and by reduced sensitivity of near-term rate expectations to economic news (Williams, 2014). The increases in equity prices in particular suggested that markets were focused on the FOMC’s signal of greater policy patience (the Odyssean aspect) rather than on an indication of greater pessimism (Delphic). Moreover, professional forecasters reacted to FOMC guidance by repeatedly marking down the unemployment rate they expected to prevail at the time that the Committee began to lift the funds rate away from zero, implying a perceived shift in the Fed’s expected reaction function (Bernanke, 2012; Femia et al., 2013). The apparent success of the FOMC’s guidance, developed on the fly, is promising for the future use of verbal interventions. As both central bankers and market participants gain experience with forward guidance, the tool should become increasingly effective. Another important distinction is between qualitative guidance (“considerable period”) and quantitative guidance, for example, describing specific economic conditions that would lead to a change in policy. Over the years, Fed guidance has evolved from qualitative towards quantitative, reflecting the desire to enhance transparency as well as the imperative of adding substantial accommodation during the ZLB period. Economic logic suggests that quantitative guidance will be more effective, because it is both more precise and more verifiable ex post (and thus easier to support by reputational concerns). However, again, a policy committee may not always be able to agree on quantitative guidance. It may also be the case that uncertainty about the economic situation favors the relative ambiguity of a qualitative formulation, at least initially. Experience suggest though that qualitative guidance, if maintained for a while, often morphs into quantitative guidance, as market participants, legislative committees, and other stakeholders press policymakers to clarify the meaning of key phrases. Yet another dimension of forward guidance is time-dependency versus state-dependency. The FOMC used both types after the crisis, indicating first that it expected to hold rates low through a certain date, then tying rate increases to thresholds based on the prevailing
unemployment and inflation rates. In principle, policy settings should depend on the state of the economy, and so state-dependent guidance should be the default in the future(Feroli et al 2016). As pointed out by williams(2016)however, date-based guidance may at times be more effective, perhaps because it is more definitive and more credible to market participants. A particular situation in which date-based guidance might be desirable arises when policymakers and the market have different economic outlooks. Suppose the ideal guidance would hold rates at zero at least until unemployment fell to 6 percent; but suppose also that market participants expect unemployment to reach 6 percent in one year while policymakers believe that unemployment will decline more slowly, reaching 6 percent in two years. In that case, state dependent guidance would be insufficiently stimulative from the policymakers point of view a greater reduction in current long-term rates and be more consistent with the policymakeo'To and time-dependent guidance(a promise that rates will remain low for two years)would achie I've been discussing forward guidance about rates, but guidance can be provided about aspects of policy other than rates, notably, about plans for asset purchases. Such guic a natural extension of rate guidance and can be Delphic or Odyssean in intent. The main point here is that guidance about the components of policy needs to be carefully coordinated, so that the planned sequencing of policy changes is clear. For example, the famous 2013 taper tantrum"followed Fed guidance that it anticipated reducing the pace of its asset purchases, conditional on economic developments. However, the tantrum reflected not so much the expectation of reduced asset purchases per se, but rather the inference in some quarters of the market(as could be seen in futures quotes) that increases in short-term rates would quickly follow the slowing of asset purchases. (See below for more on the"signaling?"aspects of quantitative easing. Fed policymakers had communicated their intention to keep rates low for a long time after the end of asset purchases, but evidently those promises had not sunk in, and The FOMC experimented with three variations of qualitative forward guidance in December 2008, March 2009 and November 2009. In August 2011, January 2012 and September 2012, the FOMC used different versions of calendar-based forward guidance in which they set a date in which they would keep rates'exceptionally low.In December 2012 the FOMC switched to a state-dependent form of forward guidance in which they committed to keeping interest rates 'exceptionally low at least as long as the unemployment rate was above 6.5%, inflation was below 2.5% based on one to two year ahead forecasts, and inflation expectations remained anchored s In principle, optimal policy depends not only on the current state of the economy but on its history as well. I discuss this point further below
8 unemployment and inflation rates.2 In principle, policy settings should depend on the state of the economy, and so state-dependent guidance should be the default in the future (Feroli et al., 2016).3 As pointed out by Williams (2016) however, date-based guidance may at times be more effective, perhaps because it is more definitive and more credible to market participants. A particular situation in which date-based guidance might be desirable arises when policymakers and the market have different economic outlooks. Suppose the ideal guidance would hold rates at zero at least until unemployment fell to 6 percent; but suppose also that market participants expect unemployment to reach 6 percent in one year while policymakers believe that unemployment will decline more slowly, reaching 6 percent in two years. In that case, statedependent guidance would be insufficiently stimulative from the policymakers’ point of view, and time-dependent guidance (a promise that rates will remain low for two years) would achieve a greater reduction in current long-term rates and be more consistent with the policymakers’ objectives. I’ve been discussing forward guidance about rates, but guidance can be provided about aspects of policy other than rates, notably, about plans for asset purchases. Such guidance is a natural extension of rate guidance and can be Delphic or Odyssean in intent. The main point here is that guidance about the components of policy needs to be carefully coordinated, so that the planned sequencing of policy changes is clear. For example, the famous 2013 “taper tantrum” followed Fed guidance that it anticipated reducing the pace of its asset purchases, conditional on economic developments. However, the tantrum reflected not so much the expectation of reduced asset purchases per se, but rather the inference in some quarters of the market (as could be seen in futures quotes) that increases in short-term rates would quickly follow the slowing of asset purchases. (See below for more on the “signaling” aspects of quantitative easing.) Fed policymakers had communicated their intention to keep rates low for a long time after the end of asset purchases, but evidently those promises had not sunk in, and 2 The FOMC experimented with three variations of qualitative forward guidance in December 2008, March 2009, and November 2009. In August 2011, January 2012 and September 2012, the FOMC used different versions of calendar-based forward guidance in which they set a date in which they would keep rates ‘exceptionally low’. In December 2012 the FOMC switched to a state-dependent form of forward guidance in which they committed to keeping interest rates ‘exceptionally low’ at least as long as the unemployment rate was above 6.5%, inflation was below 2.5% based on one to two year ahead forecasts, and inflation expectations remained anchored. 3 In principle, optimal policy depends not only on the current state of the economy but on its history as well. I discuss this point further below
coordinated reiterations of the point had to be made before market expectations re-adjusted and market conditions calmed A final observation on forward guidance: In this section I have been treating guidance, particularly of the Odyssean variety, as an ad hoc intervention, a supplement to management of the short-term rate. Alternatively, or in addition, the central bank could adopt an overarching framework that implies systematic Odyssean responses to ZLB episodes. I'll explore this possibility below, in the section on policy frameworks Q uantitative easing Probably the most controversial form of unconventional policy adopted in recent years was what the Federal Reserve called large-scale asset purchases (LSAPs) but most of the rest of the world persisted in calling"quantitative easing,", or QE. The Federal Reserve engaged in three rounds of Qe, during which its balance sheet expanded from less than a trillion dollars to $4.5 trillion. The Bank of England, European Central Bank, Swedish Riksbank, and Bank of Japan(which had pioneered asset purchases as a form of monetary policy well before the crisis) have also undertaken quantitative easin Quantitative easing involves central bank purchases of securities in the open market, financed by the creation of bank reserves held at the central bank. By law, the Fed was able to purchase only Treasury securities and mortgage-related securities issued by government- sponsored enterprises. Other central banks, in contrast, have been able to buy a range of private securities, including corporate bonds and equities. The limits on the Fed did not seem to prevent its version of QE from being effective, although it was perhaps fortunate that, following a crisis centered on housing finance, the law did permit Fed purchases of mortgage-related securities Research suggests that QE works through two principal channels, the signaling channel and the portfolio balance channel. The signaling channel arises to the extent that asset purchases serve to demonstrate the central banks commitment to monetary easing, and in particular to keeping short-term rates lower for longer(Bauer and Rudebusch, 2013). As discussed above, the sO-called taper tantrum in 2013 demonstrated the practical relevance of the signaling channel of I also tried, without success, to name the program"credit easing, to distinguish it from the Bank of Japan's earlier foray into asset purchases(Bernanke, 2009). I argued that"credit easing focused on removing duration from bond markets, in contrast to BOJ-style quantitative easing, which had the primary goal and metric of increasing the high wered money stock
9 coordinated reiterations of the point had to be made before market expectations re-adjusted and market conditions calmed. A final observation on forward guidance: In this section I have been treating guidance, particularly of the Odyssean variety, as an ad hoc intervention, a supplement to management of the short-term rate. Alternatively, or in addition, the central bank could adopt an overarching framework that implies systematic Odyssean responses to ZLB episodes. I’ll explore this possibility below, in the section on policy frameworks. Quantitative easing Probably the most controversial form of unconventional policy adopted in recent years was what the Federal Reserve called large-scale asset purchases (LSAPs) but most of the rest of the world persisted in calling “quantitative easing”, or QE.4 The Federal Reserve engaged in three rounds of QE, during which its balance sheet expanded from less than a trillion dollars to $4.5 trillion. The Bank of England, European Central Bank, Swedish Riksbank, and Bank of Japan (which had pioneered asset purchases as a form of monetary policy well before the crisis) have also undertaken quantitative easing. Quantitative easing involves central bank purchases of securities in the open market, financed by the creation of bank reserves held at the central bank. By law, the Fed was able to purchase only Treasury securities and mortgage-related securities issued by governmentsponsored enterprises. Other central banks, in contrast, have been able to buy a range of private securities, including corporate bonds and equities. The limits on the Fed did not seem to prevent its version of QE from being effective, although it was perhaps fortunate that, following a crisis centered on housing finance, the law did permit Fed purchases of mortgage-related securities. Research suggests that QE works through two principal channels, the signaling channel and the portfolio balance channel. The signaling channel arises to the extent that asset purchases serve to demonstrate the central bank’s commitment to monetary easing, and in particular to keeping short-term rates lower for longer (Bauer and Rudebusch, 2013). As discussed above, the so-called taper tantrum in 2013 demonstrated the practical relevance of the signaling channel of 4 I also tried, without success, to name the program “credit easing,” to distinguish it from the Bank of Japan’s earlier foray into asset purchases (Bernanke, 2009). I argued that “credit easing” focused on removing duration from bond markets, in contrast to BOJ-style quantitative easing, which had the primary goal and metric of increasing the highpowered money stock