In the wake of the Great Recession, the Fed needed every policy tool it could find. Quantitative easing, forward guidance of policy goals and targets, and lowering interest rates to 0 percent are the most obvious examples. Now, QE has ceased, and the Fed funds rate is back above 1 percent. In contrast, forward guidance is more active than ever and there do not appear to be plans to wind it down. But, with many of the crisis era measures already scaled back, it is time to taper forward guidance too.
There is no question forward-guidance can be useful. Following the financial crisis, it was utilized to steer market participants toward the “lower for longer” mantra and then keep them there. Markets could be confident that the Fed would stick to its policy prescriptions because it said so. Monetary policy became contingent on economic outcomes that the Fed made explicit. By sticking to its forecasts some credibility was gained for forward guidance. There was confidence in the Fed’s willingness to follow through on what it said.
There have also been problems with the concept of forward guidance. The dot plot is a perfect example. The dot plot is the Fed’s way of communicating the path of future fed funds policy, and its accuracy has been suspect at best. Instead of providing insight into future Fed policy, it could be more accurately described in practice as the idealized path of the fed funds rate. It has been inaccurate to the point of uselessness most of the time. For example, in September 2014, the Fed predicted the fed funds rate would be 3.75 percent at the end of 2017. It is widely expected that the Fed will raise rates to the 1.25 percent – 1.5 percent range by December. The Fed over-estimated its ability to raise rates by 2.25 percent.
“The dot plot is the Fed’s way of communicating the path of future fed funds policy, and its accuracy has been suspect at best.”
At a recent conference, Fed Chair Janet Yellen defended the forward guidance as useful, though she warned against overuse. Yellen, in bringing up the number of voices and opinions from the Fed, shed some light on the problem of forward-guidance and transparency: Too many economists with too many opinions and no useful guidance. Yellen correctly sees this as a problem and makes the distinction between a useful tool and an abused tool. She is defending a precision tool of gentle market guidance, not the tool of mass opinion dissemination that it has become.
There are few reasons to suspect a slowdown in the near-term, but there should be a concerted effort to reduce the amount of Fed noise in the future and maximize the amount of signal, i.e., the useful information regarding the direction of future policy, not useless blather.
That is exactly what the Fed should do—stop talking. There is little reason to have regional Fed presidents be celebrities. The Fed’s current policies are not difficult to communicate. The balance sheet is on an autopilot schedule for reduction, and rate hikes are highly dependent on inflation developments in 2018. Granted, there is a substantial differential between the number of hikes the Fed is forecasting and the number the market anticipates in 2018. But does this gap necessitate constant updates from the Fed? After all, the Fed is on track to give more speeches this year than ever before. With most of the speeches at least giving an opinion on how monetary policy would unfold.
Certainly, there are reasons forward-guidance should be maintained. For instance, eliminating forward guidance might be taken as a pseudo-tightening by a trigger-happy market. But there is also the need to wind it down. The Fed cannot simply stop providing forward-guidance. It will need to ease its way out.
Few better times will appear than the present to taper forward guidance. The incoming Fed Chair, Jerome Powell, deserves the ability to shape monetary policy the way he sees fit. Forward guidance effectively corners the new Fed Chair into a continuation of the current monetary policy. Continuity should not be disparaged, having predictable and steady monetary policy is positive. But it also leaves precious little room to operate.
St. Louis Fed President James Bullard suggested an interesting place to start the taper—the Summary of Economic Projections issued quarterly. The SEP contains the dot plot and Fed projections of inflation and GDP growth. Bullard’s idea is to replace the SEP with a quarterly report, that contains information less susceptible to large errors. It would at least be a start. But the Fed should go one step further. The Fed should cap the number of speeches that its members can give, and cease the practice entirely relatively soon.
With the Fed pulling back from the majority of its post-crisis measures, it is time to look at its communication policy. I don’t see any reason for the Fed to be guiding incessantly at this point. It might be great job security for economists, but it makes little sense to have every regional Fed president and governor giving their opinion on the economy. At this point, the Fed’s transparency is probably doing more harm than good.