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posted on 19 October 2016

From The Vault: Does Forward Guidance Work?

from Liberty Street Economics

-- this post authored by Anna Snider

In recent months, there have been some high-profile assessments of how far the Federal Reserve has come in terms of communicating about monetary policy since its “secrets of the temple" days. While observers say the transition to greater transparency “still seems to be a work in progress," they note the range of steps the Fed has taken over the years to shed light on its strategy, including issuing statements to announce and explain policy changes following Federal Open Market Committee (FOMC) meetings, post-meeting press conferences and minutes, FOMC-member speeches and testimony, and “forward guidance" in all its variants.

The evolution to openness stems from a theoretical argument that central banks can enhance the effectiveness of monetary policy by projecting a path for the federal funds rate and then clearly communicating how changes in the economic outlook might alter it. That sets up an expectations dynamic where households and businesses can “count on" the Fed’s responses to new developments. In a climate of easing, markets would react by driving down long-term interest rates on the expectation that the Fed will lower the policy rate, thus doing the “heavy lifting" to bolster the economy.

Several posts on Liberty Street Economics take note of the tools and approaches that economists use to measure the potential and effectiveness of forward guidance. For example, Richard Crump, Stefano Eusepi, and Emanuel Moench take advantage of a real-world laboratory created by an FOMC meeting in August 2011 when policymakers notably altered guidance. (The post-meeting FOMC statement shifted from saying economic conditions warranted an exceptionally low policy rate “for an extended period" to a more specific date “at least through mid-2013.") Their analysis exploits the timing of surveys in a narrow window just before and after the meeting to show, among other things, that professional forecasters changed their expectations for monetary policy “considerably" and in a manner consistent with the language in the FOMC statement.

In another post, the same authors examined what happened to both market- and survey-based measures of the path of future interest rates in the wake of a June 2013 FOMC meeting. Interestingly, financial market measures (for example, the two-year Treasury yield and a key forward rate) shot up just after the meeting, while professional forecasters’ expectations remained steady. Our bloggers say forecasters “did not interpret Fed communication around the FOMC meeting as signaling a change" in the likely path for the federal funds rate (FFR). Instead, the behavior of rates was attributable to rising term premia, a measure of interest rate risk receiving heightened attention in research, policy discussions, and central bank communications.

Elsewhere on the blog, our economists explained how they use DSGE (dynamic stochastic general equilibrium) models to estimate the effects of forward guidance on macroeconomic variables such as GDP growth, core PCE inflation, and the federal funds rate. A simulation outlined in the post in which the FOMC committed to extending the “liftoff" date of the FFR for two quarters had “implausibly" large effects, including a sharp spike in GDP growth over the next two years, the authors found. But experimentation with a more realistic upper bound on the response of the long-term bond yield showed that “a policy-driven shift in in FFR market expectations . . . would have sizable, though reasonable, effects on GDP growth but only a modest impact on inflation."

That the initial simulation drove such a large change in GDP remains “a forward guidance puzzle," the authors said. Nonetheless, they argue that DSGE models, even with their limitations, are useful to policymakers in trying to estimate the potential effects of their interventions, “particularly when alternative approaches are lacking."

Reading List

Making a Statement: How Did Professional Forecasters React to the August 2011 FOMC Statement?

Richard Crump, Stefano Eusepi, and Emanuel Moench

Preparing for Takeoff? Professional Forecasters and the June 2013 FOMC Meeting

Richard Crump, Stefano Eusepi, and Emanuel Moench

The Recent Bond Market Selloff in Historical Perspective

Tobias Adrian and Michael Fleming

The Macroeconomic Effects of Forward Guidance

Marco Del Negro, Marc Giannoni, and Christina Patterson


The views expressed in this post are those of the author and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the author.


About the Author

Anna Snider is a cross-media editor in the Federal Reserve Bank of New York’s Research and Statistics Group.

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