As far as I can tell, Yellen did not actually say anything in the semi-annual report. So there is nothing to comment on, besides admitting that the wisening up (by my lights) that I have been hoping for did not happen today. I will talk about something else.
The Fed has been providing guidance on the funds rate for so long now that it is easy to forget that in the longer sweep of things guidance is actually unusual. Moreover, hawkish guidance – of the sort the Fed is now trying to offer – is arguably a logical contradiction and might best be abandoned.
In normal circumstances, when the Fed can as easily cut as raise interest rates, there is not much case for guidance. The Fed does not have a reliable growth and inflation forecast and cannot reliably estimate the effect on the economy of changes in its policy rate. Accordingly, it cannot reliably guide where interest rates are headed.
Instead, it commits to hitting its inflation and employment objectives and is relatively quiet on how this will be achieved, beyond insisting that policy will tighten or ease as circumstance requires. The obvious analogy is to driving a car. You cannot say how hard you will hit the gas or brakes, because you do not know the road conditions. But you can still have a plan for how quickly you will drive or would like to drive.
That was the normal state of affairs, which described the Fed’s actual behavior for most of its history prior to the financial crisis, when the zero bound on interest rates came into effect. Once the zero bound was hit, the Fed had to search for additional ways of providing stimulus, which led to the QE smoke and mirrors and, more substantially, to dovish rates guidance.
In order to drive down the priced forward path of the funds rate and thus medium-term bond yields, the Fed committed to leaving rates at zero for a particular period of time, until certain economic conditions were met, or both.
This involved surrendering some flexibility and committing to a policy path that might ultimately prove sub-optimal. But that was a price they judged worth paying to get the additional stimulus. And as things turned out, the commitment did not end up constraining the Fed. What they promised to do and what they ended up preferring to do were pretty close.
But now the Fed is offering hawkish guidance, which seems to make a lot less sense. The fact that they are in the process of raising interest rates – however slowly – is proof that they are no longer casting about for additional means of stimulus. So the main case for guidance is actually expired.
In this environment, they could just as easily – or indeed more easily – deliver the desired set of financial conditions if they just said, as they used to, that policy will adjust as required to hit their objectives. This would put the focus on the objectives where it belongs and away from guidance that the Fed can probably not actually deliver on.
By dropping guidance, the Fed could also put itself in a position where it is less exposed to cognitive dissonance and the desire to defend previous wrong forecasts. For example, right now they are saying that they plan to raise interest rates because policy is quite “accommodative.” That statement has the disadvantage and advantage of not actually meaning anything. For example, policy seems to be “accommodating” an undesired collapse of inflation breakevens.
They would be better off if they admitted to being mere mortals like the rest of us and insisted they don’t know what the future holds. This would leave them freer to discern and then deliver the right policy response. At this point, their guidance is holding them back.
I can anticipate two retorts to this argument. The first is that the Fed is not really delivering “hawkish” guidance. After all, they are promising to raise rates only slowly and are promising to keep rates low relative to normal. My response to that retort is that the Fed does not really know what slowly or normal are and their rates guesses are above the market pricing. So let’s not be distracted by semantics. The point is that they are offering guidance at a time when they are – by definition – not casting about for additional means of stimulus.
The second retort might be that the Fed now has a process of delivering rates guidance and it will be difficult for them to give that up. Could Yellen really get away with saying rates guidance is for the zero bound and pointless otherwise, as I believe is the case? I think she could, assuming she agreed with me. I think the markets could handle that, although the usual suspects would do their usual freak out. But, fwiw, I recognize that she probably won’t.
That makes it awkward. The implication is, don’t put much stock in those Fed rates guesses. To her credit, Yellen does mention that every time she trots them out. She says here are our guesses and here is why you should ignore them. Better to just drop them.