Mixed Signals and Monetary Policy Discretion

Two recent Economic Letters from the Federal Reserve Bank of San Francisco highlight the difficulty of making monetary policy decisions when alternative measures of labor market slack and the output gap give mixed signals. In Monetary Policy when the Spyglass is Smudged, Early Elias, Helen Irvin, and Òscar Jordà show that conventional policy rules based on the output gap and on the deviation of the unemployment rate from its natural rate generate wide-ranging policy rate prescriptions. Similarly, in Mixed Signals: Labor Markets and Monetary Policy, Canyon Bosler, Mary Daly, and Fernanda Nechio calculate the policy rate prescribed by a Taylor rule under alternative measures of labor market slack. The figure below illustrates the large divergence in alternative prescribed policy rates since the Great Recession.

Source: Bosler, Daly, and Nechio (2014), Figure 2

Uncertainty about the state of the labor market makes monetary policy more challenging and requires more discretion and judgment on the part of policymakers. What does discretion and judgment look like in practice? I think it should involve reasoning qualitatively to determine if some decisions lead to possible outcomes that are definitively worse than others. For example, here's how I would reason through the decision about whether to raise the policy rate under high uncertainty about the labor market:

Suppose it is May and the Fed is deciding whether to increase the target rate by 25 basis points. Assume inflation is still at or slightly below 2%, and the Fed would like to tighten monetary policy if and only if the "true" state of the labor market x is sufficiently high, say above some threshold X. The Fed does not observe x but has some very noisy signals about it.  They think there is about a fifty-fifty chance that x is above X, so it is not at all obvious whether tightening is appropriate. There are four possible scenarios:

1. The Fed does not increase the target rate, and it turns out that x>X.
2. The Fed does not increase the target rate, and it turns out that x<X.
3. The Fed does increase the target rate, and it turns out that x>X.
4. The Fed does increase the target rate, and it turns out that x>X.

Cases (2) and (3) are great. In case (2), the Fed did not tighten when tightening was not appropriate, and in case (3), the Fed tightened when tightening was appropriate. Cases (1) and (4) are "mistakes." In case (1), the Fed should have tightened but did not, and in case (4), the Fed should not have tightened but did. Which is worse?

If we think just about immediate or short-run impacts, case (1) might mean inflation goes higher than the Fed wants and x goes even higher above X; case (4) might mean unemployment goes higher than the Fed wants and x falls even further below X. Maybe you have an opinion on which of those short-run outcomes is worse, or maybe not. But the bigger difference between the outcomes comes when you think about the Fed's options at its subsequent meeting. In case (1), the Fed could choose how much they want to raise rates to restrain inflation. In case (4), the Fed could keep rates constant or reverse the previous meeting's rate increase.

In case (4), neither option is good. Keeping the target at 25 basis points is too restrictive. Labor market conditions were bad to begin with and keeping policy tight will make them worse. But reversing the rate increase is a non-starter. The markets expect that after the first rate increase, rates will continue on an upward trend, as in previous tightening episodes. Reversing the rate increase would cause financial market turmoil, damage credibility, and require policymakers to admit that they were wrong. Case (1) is much more attractive. I think any concern that inflation could take off and get out of control is unwarranted. In the space between two FOMC meetings, even if inflation were to rise above target, inflation expectations are not likely to rise too far. The Fed could easily restrain expectations at the next meeting by raising rates as aggressively as needed.

So going back to the four possible scenarios, (2) and (3) are good, and (4) is much worse than (1). If the Fed raises rates, scenarios (3) and (4) are about equally likely. If the Fed holds rates constant, (1) and (2) are about equally likely. Thus, holding rates constant under high uncertainty about the state of the labor market is a better option than potentially raising rates too soon.

Most Households Expect Interest Rates to Increase by May

Two new posts on the New York Federal Reserve's Liberty Street Economics Blog describe methods of inferring interest rate expectations from interest rate futures and forwards and from surveys conducted by the Trading Desk of the New York Fed. In a post at the Atlanta Fed's macroblog, "Does Forward Guidance Reach Main Street?," economists Mike Bryan, Brent Meyer, and Nicholas Parker, ask, "But what do we know about Main Street’s perspective on the fed funds rate? Do they even have an opinion on the subject?"

To broach this question, they use a special question on the Business Inflation Expectations (BIE) Survey. A panel of businesses in the Sixth District were asked to assign probabilities that the federal funds rate at the end of 2015 would fall into various ranges. The figure below compares the business survey responses to the FOMC's June projection. The similarity between businesspeoples' expectations and FOMC members' expectations for the fed funds rate is taken as an indication that forward guidance on the funds rate has reached Main Street.

What about the rest of Main Street-- the non-business-owners? We don't know too much about forward guidance and the average household. I looked at the Michigan Survey of Consumers for some indication of households' interest rate expectations. One year ago, in December 2013, 61% of respondents on the Michigan Survey said they expected interest rates to rise in the next twelve months. Only a third of consumers expected rates to stay approximately the same. According to the most recently-available edition of the survey, from May 2014, 63% of consumers expect rates to rise by May 2015.

The figure below shows the percent of consumers expecting interest rates to increase in the next twelve months in each survey since 2008. I use vertical lines to indicate several key dates. In December 2008, the federal funds rate target was reduced to 0 to 0.25%, marking the start of the zero lower bound period. Nearly half of consumers in 2009 and 2010 expected rates to rise over the next year. In August 2011, Fed officials began using calendar-based forward guidance when they announced that they would keep rates near zero until at least mid-2013. Date-based forward guidance continued until December 2012. Over this period, less than 40% of consumers expected rate increases.

In December 2012, the Fed adopted the Evans Rule, announcing that the fed funds rate would remain near zero until the unemployment rate fell to 6.5%. In December 2013, the Fed announced a modest reduction in the pace of its asset purchases, emphasizing that this "tapering" did not indicate imminent rate increases. The share of consumers expecting rate increases made a large jump from 55% in June 2013 to 68% in July 2013, and has remained in the high-50s to mid-60s since then.

But since 1978, the percent of consumers expecting an increase in interest rates has tracked reasonably closely with the realized change in the federal funds rate over the next twelve months (fed funds rate in month t+12 minus fed funds rate in month t). In the figure below, the correlation coefficient is 0.26. As a back-of-the-envelop calculation, if we regress the change in the federal funds rate in twelve months on the percent of consumers expecting a rate increase, the regression coefficients indicate that when 63% of consumers expect a rate increase, that predicts a 25 basis points rise in rates in the next year.

This survey data does not tell us for sure that forward guidance has reached Main Street. The survey does not specifically refer to the federal funds rate, just to interest rates in general. And households could simply have noticed that rates have been low for a long time and expect them to increase, even without hearing the Fed's forward guidance.  In an average month, 51% of consumers expect rates to rise over the next year, with a standard deviation of 15%. So the values we're seeing lately are about a standard deviation above the historical average, but they have been higher historically. In the third and fourth quarters of 1994, after the Fed had already begun tightening interest rates, 75-80% of consumers expected further rate increases. At the start of 1994, however, only half of consumers anticipated the rate increases that would come.

In May 2004, the FOMC noted that accommodation could “be removed at a pace that is likely to be measured.” That month, 85% of consumers (a historical maximum) correctly expected rates to increase.

A Cyber Monday Message of Thanks

Cyber Monday may just be a marketing tool, but I'll take it as an opportunity to send a cyber-message of thanksgiving out to all of you who are connected to me through my blog.

I started this blog in September 2012 but only started posting regularly in January 2013, after attending a panel discussion at the 2013 AEA meetings called "Models or Muddles: How the Press Covers Economics and the Economy." The panel members, Tyler Cowen, Adam Davidson, Kelly Evans, Chrystia Freeland, and David Wessel, discussed the importance and challenge of writing intellectually upright and emotionally compelling economic journalism. I took their discussion as an invitation to try my hand at economics blogging, and I immensely appreciate every one of you who have read, shared, criticized, complemented, and challenged my writing along the way. Most of you are anonymous, but several of you I feel that I know personally. All of you have helped me improve and inspired me to continue.

I blog mostly for myself. It is a remarkable opportunity to think through new ideas, evaluate recent research, and learn about important policy issues. When I started the blog, I was quite new to economics. I was a math major as an undergraduate, so my first year of graduate school at Berkeley was a boot camp-style introduction to economic theory and analysis. Now, in my final year of graduate school, I am still relatively new to the field, but blogging has helped me develop a broader and more nuanced and contextualized understanding of economics than I could have achieved from school alone.

I blog mostly for myself, but not only for myself. I entered an economics Ph.D. program because I fundamentally wanted to help people and make a difference in the world, as naive as that may sound. Now, looking over at my brand new baby daughter, that is still what I want, even more so than five years ago, though I think I have a more subtle understanding of "making a difference" than I used to. That is also why I want to thank you, readers. I do not give you investment advice, teach you how to get rich quick, or provide juicy ad hominem attacks to entertain you. If you're reading my blog, it's probably because you also have an intellectual interest in economics also stemming, I like to believe, from your desire for a better world. Thanks.