Once upon a time, central bankers touted forward guidance as an invaluable policy tool. With interest rates hovering close to zero in the world’s advanced economies, policy makers used talk therapy to their advantage. Tell the public — the financial markets, really — your objective and how you plan to achieve it, and they will do the work for you by incorporating tomorrow’s expectations into today’s prices.
That’s all well and good when policy makers know what they plan to do and when they plan to do it. During the extended period of near-zero interest rates from December 2008 to December 2015, the Federal Reserve used its pledge to keep short-term interest rates low for an extended period to prevent long-term interest rates from rising. (The long-term rate is the sum of the current and expected future short-term rates.)
Now the crystal ball is getting cloudy. Last week, in a widely telegraphed move, the Federal Reserve raised its benchmark rate by 25 basis points to a range of 2% to 2.25%. Missing from the post-meeting statement was the boilerplate language — “the stance of monetary policy remains accommodative” — that had been a fixture since 2015.
That change inspired a clarification from Fed Chairman Jay Powell at his post-meeting press conference.
“I think the point with accommodative was that its useful life was over,” Powell said, in response to a reporter’s question. Policy makers’ forecasts for the federal funds rate indicate that the current rate is still below the perceived neutral rate, implying that policy “is still accommodative,” Powell said.
Hiding in plain sight, in other words.
Next up was John Williams, president of the New York Fed. In a speech on Friday, Williams discussed the evolution of monetary policy normalization, from lift-off to normalization to normal, and noted that “changing circumstances call for some changes in how the FOMC communicates its policy views.”
Those changes include a “slimming down” of the policy statement and “less forward guidance” at a time when “the future direction of policy will no longer be as clear as it was during the past few years,” he said.
Williams even downplayed the importance of estimating the neutral, or natural, rate of interest, known as r*. Williams has devoted a considerable body of research to star-gazing: determining the unobservable rate that keeps the economy growing at its potential. Now, as the current funds rate closes in on the neutral rate, what was once “a pole star for navigation” and “a bright point of light” is now “a fuzzy blur,” according to Williams.
That’s quite a shift for the former San Francisco Fed president — and for the Fed in general.
After years of spoon-feeding, financial markets will have to learn to walk on their own? Can they handle it? What would happen if, for some reason, the Fed had to deliver a tablespoon of interest-rate medicine (50 basis points) instead of the prescribed teaspoon?
I doubt that surprise will be a part of the Fed’s policy toolkit. But the acknowledgment by Powell & Co. that they don’t know what they will do next, when that will be or what the final destination is, certainly qualifies as a major shift. (Perhaps it’s time for the Fed to reactivate its communication committee.)
If we’ve learned anything from Powell since he assumed the chairmanship of the Fed in February, it’s that he is not married to any model. He is a pragmatist. He knows what he doesn’t know. He will be monitoring incoming data on the economy, financial conditions and developments in financial markets for signs that the Fed needs to adjust its slow-and-steady approach to raising rates.
He often speaks of “navigating between the two shoals:” of raising rates too quickly and snuffing out the expansion; or moving too slowly and risking an inflationary outburst.
For Powell, gradualism is the solution. Adjust interest rates, observe how the economy and markets react, rinse and repeat.
That’s all well and good except for the fact that monetary policy works with long and variable lags. Central bankers have yet to perfect a technique for orchestrating a soft landing: Raising interest rates just enough to reduce the economy’s growth rate to its non-inflationary potential before downshifting to neutral to avoid sending the economy into recession.
This is exactly the type of situation where forward guidance would be beneficial, with the Fed on the receiving end and financial markets dispensing the advice.
