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Forward Guidance: Theory versus Reality

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Forward Guidance: Theory versus Reality

February 9, 2015

Mainstream monetary economics posits that the Federal Reserve influences economic activity by shaping expectations about the future.  According to theory, when the Fed provides “forward guidance” about the future course of monetary policy, consumers and producers adjust their spending, hiring, and investment decisions accordingly.  Forward guidance, in turn, can be communicated to the public via statements from Fed officials or public understanding of a policy rule that leads the Federal Open Market Committee to adjust its target for the federal funds rate.

This theory might, or might not, be an accurate description of how Federal Reserve actions are transmitted to aggregate spending and prices.  But, for the time being, it is useful to examine the nature of forward guidance that the Fed is delivering to the public.

Dealing first with the information that might be gleaned from a policy rule, we take the FOMC’s consensus projections for variables it considers to be objectives of monetary policy and insert them into such a rule.  It is important to note that, at least publicly, the Fed never has announced that it is following any rule. One rule that is embedded into standard macroeconomic models used by economists and monitored by many observers of monetary policy originates from John Taylor of Stanford University.  In its original 1993 formulation, the Taylor rule can be expressed as:

ff = p + (1/2)(y − y*) + (1/2)(p − p*) + 2,

where ff is the setting for the federal funds rate, y is the level of real GDP, y* is the level of potential output, p is the actual inflation rate, and p* is the FOMC’s inflation target.  Thus, the Taylor rule calls for the Fed to raise or lower the funds rate whenever GDP rises above or falls below potential and whenever inflation rises above or falls below target.

To operationalize Taylor’s rule, we make three minor changes to his original specification.  First, we substitute p*=2 into the equation, to reflect FOMC’s two percent inflation target, first announced in January 2012.  Second, to measure inflation, we use year-over-year percentages change in the deflator for personal consumption expenditures excluding food and energy instead of the GDP deflator, Taylor’s own choice, since the FOMC has identified core PCE price inflation as its preferred measure.  Finally, we replace the linear trend that Taylor used to measure potential GDP with the Congressional Budget Office’s more sophisticated measure, to allow for the possibility that lingering effects of the financial crisis and recession of 2008 continue to affect the U.S. economy’s long-run potential.

Using central tendencies for real GDP and core PCE inflation reported in the “Summary of Economic Projections” Appendix to the Minutes of their December 16-17, 2014 meeting, we then calculate settings for the federal funds rate that are consistent with the Taylor rule.  These settings turn out to be 2.4 percent for year-end 2015 and 3.1 percent for year-end 2016.

Finally, we compare these recommendations from the Taylor rule to values for the funds rate that FOMC members deemed “appropriate,” again as reported in the Appendix to their December Minutes.  The table below summarizes these views, recording the number of members of the FOMC who believe the target should be set within alternative ranges.  For the end of 2015, eight of the 17 members believe the target for the funds rate should be set at or below one percent, while the remaining nine members offered the view that the funds rate should be above one percent but less than or equal to two percent. Strikingly, none of the FOMC members views as appropriate a setting within 40 basis points of the value suggested by the Taylor rule.

The divergence between the value of the funds rate suggested by the Taylor rule and the opinions of FOMC members is somewhat less pronounced, but still evident, for the end of 2016.  The Taylor rule suggests a value of 3.1 percent, while 11 members offer the opinion that the target should remain below 3 percent and 6 suggest it should be above that level.  Four members, however, continue to see a funds rate target at or below 2 percent as appropriate for this later period.  These data suggest considerable variation within the FOMC about the future course of monetary policy as well as substantial differences from values implied by the Taylor rule.  It would seem, therefore, that the FOMC either is not adhering to the guidance offered by this rule or that it is following an unknown variant of it.

Divergence of opinion among members of the FOMC also can be seen in their contrasting public statements.  The Wall Street Journal’s Michael Derby, for instance, assembled a set of statements from each member of the FOMC for a period spanning late September through mid-October 2014.  Although these statements exhibit considerable range for interpretation, one reading of them is that five members prefer no change in the funds rate for the foreseeable future and four prefer increasing the funds rate sooner rather than later.  The remaining eight members offer generic views on monetary policy – e.g., that an independent central bank produces better policy outcomes or that any decision about the future settings of the funds rate target will depend on the evolution of economic variables important to monetary policy decisions.  It is noteworthy that Chair Janet Yellen is one of the two members who, in this timeframe, offered no views on the Fed’s interpretation of economic performance or a likely future course for the federal funds rate target.

If forward guidance is, in fact, an important influence on spending and production, the information in these two tables appears to reveal little that would be useful for consumers or producers.  Although many observers interpret the stance of monetary policy using some variant of the Taylor rule, most members of the FOMC express options of the appropriate level for the funds rate that, given their own forecasts for output and inflation, deviate considerably from the values generated by that rule.  Moreover, public statements by FOMC members differ on two important points: Whether the funds rate target should be increased or left unchanged and, if that target is to be raised, when the increase should occur.

Because this overview suggests that the Fed may be confusing rather than enlightening the public, the practices and performance of other central banks may be worth examining.  For example, the Bank of Canada has a Governing Council but, once its deliberations have concluded, only its consensus views are revealed to the public. The Bank of England makes decisions based on input from members of its Monetary Policy Committee and these individuals, like members of the FOMC, are free to offer to the public their own views on economic conditions and a preferred path for the future course of monetary policy. It might be interesting to ask Mark Carney, who has served as the Governor of both the Bank of Canada and the Bank of England, which institutional arrangement makes monetary policy easier to implement and produces better policy outcomes.  It might be useful, as well, to investigate and evaluate further the reasons why Stephen Poloz, the new Governor of the Bank of Canada, recently decided to abandon his Bank’s practice of offering forward guidance on its policies.


Michael Belongia is a professor of economics at the University of Mississippi. Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.

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