Winner of the New Statesman SPERI Prize in Political Economy 2016

Saturday, 1 March 2014

Forward Guidance is not Forward Commitment

Some recent discussions I have had with those who follow monetary policy in the UK and US, and indeed some who actually make that policy, suggest deep confusion between forward guidance and forward commitment. By forward commitment I mean a policy of committing to a future stimulus that would raise future output and inflation, in order to assist the current recovery. This is the policy that was first suggested by Paul Krugman for Japan and championed by Michael Woodford in particular. For more background, I discussed a recent paper exploring this policy here.

Why am I so confident that central banks are not undertaking this policy? First, because this policy only works through its influence on expectations. So those undertaking forward commitment have to be completely clear about what they are doing. The more opaque they are about the policy, the less effective it will be, particularly as the policy is time inconsistent. (The central bank has an incentive to change its mind once the recession is over)

Second, there is a defining characteristic of a forward commitment policy that no central bank has so far committed to, and that is to raise output above its natural rate (or equivalently to reduce unemployment below its natural rate) in the future. In short, to create a future boom. So, if that is a defining characteristic of the policy, yet no central bank has committed to do this, then as the policy has to be clear to be effective it must follow that central banks are not following the policy.

So why the confusion? First, I think there is a presumption that central bank communication will always be obscure, and that money can be made from trying to decipher their true intentions. Sometimes that may be true. In those circumstances, statements by certain policymakers that talked positively about a Woodford type policy might be relevant. However for this particular policy clarity is central. To pursue forward commitment yet to be mysterious about doing so is like announcing that you are targeting inflation but not announcing what your inflation target is.

The second source of confusion comes from focusing on inflation. A second feature of the forward commitment policy is that inflation will be above target during the boom (and perhaps before). So some have taken the part of forward guidance that says the central bank will be relaxed about inflation up to 2.5%, when their target is 2%, as indicating forward commitment. Yet that same forward guidance also features unemployment thresholds, which are above the estimated natural rate. [1] That would be a perverse thing to announce as part of forward commitment, because the whole idea is to get future unemployment below its natural rate.

A much more plausible explanation of forward guidance in the UK and US is that it is clarifying the short term trade-off the central bank will allow between inflation and unemployment. That could simply be informing the public about existing policy at a time when shocks might push inflation above target without also pushing output above the natural rate. Alternatively it could be indicating a change in that trade-off - a change in policy. In either case, the framework of that policy is entirely traditional. There is no commitment to engineer a future boom.

If I am right about this, it raises the interesting question of why no central banks during this recession have tried forward commitment. A closely related question is why no central banks have established price level or nominal GDP targets. In the case of the former this is the puzzle addressed in a recent paper by Steve Amber. To quote from the introduction: “Price-level targeting has convincing advantages, especially as a tool for avoiding the worst consequences of economic downturns. Then why haven’t central banks experimented with the regime?” He suggests that central banks are too fond of their current discretion to make this kind of commitment. If I have something interesting to say about this it will be for a future post.

[1] Here is the Fed's discussion of forward guidance. It suggests that it will be "appropriate to maintain the current target range for the federal funds rate well past the time that the unemployment rate declines below 6-1/2 percent". But at no point does it say it intends to reduce unemployment below the natural rate (between 5% and 6%) in order to raise inflation above target in the future. 

4 comments:

  1. I think that the reason why forward committment has concentrated on inflation is that Krugman's writings (which pre-date Woodford's as far as I know) have explained the mechanism as embedding expectations of negative real rates of interest. In a fuller model this would also imply that unemployment would fall below the natural rate for a while, but the focus in the blogs has been on the negative real interest rate

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  2. I have just read David Runciman's article in the LRB about Blair's autobiography (Preacher on a Tank, 7 October 2010).

    Runciman says that in Mandelson's autobiography Mandelson claims that he tried in 2003 to get Blair to split the Treasury into a Ministry of Finance restricted to macroeconomics for Brown to remain head of, and an Office of Budget and Delivery for Blair to control and which would have done all the government spending.

    This 'Operation Teddy Bear' shows, as well as the Labour infighting, of how little import macroeconomics was (is?) seen in the Labour Party.

    Is it any surprise that the central bankers feel no political pressure to buck their ideas up because, well, there isn't.

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  3. Describing the policy in terms of inflation overshooting of the long-run target instead of unemployment undershooting are just two sides of the same coin. And if the public thinks that it is inflation hawks that are primary source of any (real or imagined) defection from that commitment, stating it in inflation terms can be helpful in demonstrating that hawks are prepared to tolerate that outcome. Credibly setting an unemployment rate threshold at the natural rate of unemployment is certainly a sufficient condition for producing a post-liftoff boom but it is not a necessary one in an economy with intrinsic inertia.

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  4. Any thoughts on the savings groups arguing for higher interest rates Prof WL? Unfortunately I could only find the Daily Mail mention, but it was making the rounds in other papers earlier this week.

    http://www.dailymail.co.uk/news/article-2570695/Savers-lost-326bn-Bank-Englands-decision-lower-rates-researchers-say.html

    A nation addicted to debt? A crime against the working man? Savings earned by the hard graft whisked away on a wind of inflation?

    Competitive industry? Home and C&I loans? Rampant productivity avoiding another depression? De facto debt relief for a nation that was already borrowing heavily?

    Who will win?

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