Lose the guidance: II

This is a case more of me catching up than of potentially being interesting.

I have been pushing the idea that the Fed should lose its interest rate guidance because it serves no purpose when policy is away from (the logic of) the zero bound and is a source mostly of anchoring and cognitive dissonance.

I should have mentioned that the Chicago Booth school’s US Monetary Policy Forum in late February focused on this issue and had a fun paper by, as usual, some academics and practitioners from Wall Street.  Strictly speaking, my initial blog post fully elaborating this idea was not a miss, because it predated the paper by two whole weeks!  But I have been returning to this theme, without mentioning that paper, of which I was not aware. So here is the paper, written with more formality and rigor (and length) than my own post(s).

I would lean on this paper mostly to say, I told you so.  But there are a couple minor elements of it that are inconsistent.  The authors claim that the caveats the Fed has placed around its time-based forward guidance (the dot plots) are ignored by the markets.  Markets take the forward guidance to be a forecast, rather than a highly conditional guesstimate of how the path of interest rates might evolve were the Fed’s forecast for the economy to prove accurate, which it never does.

But the authors also claim that the Fed has lost credibility with the markets and that the markets have basically ignored the Fed’s projections.  Presumably, the cost of this is a loss of credibility.

They cannot have it both ways. Either the markets are inclined to accept or are not. Plus I think they put the emphasis on the wrong issue. The issue here is not that the Fed might lose “credibility.”

So far as I know, there is no social value added to the Fed doing the impossible (away from zero bound)  and properly guessing the right path of its – instrument – the Fed funds rate. The Fed must remain credible on its objectives, full employment and price stability, and guessing wrong on rates does not really put them at risk on the credibility that actually matters.

Rather, I would guess that the main cost of guessing the path of the instrument is that it leads to anchoring and to very tortured story telling when the guesses inevitably go wrong.  For example, Yellen thew into the mix that Brexit was one reason the Fed did not go in June. Really? Without Brexit they might have gone? Please.

That cognitive dissonance could possibly  lead to bad policy, although in fairness to the Fed, I cannot point to a case where it actually has. It can also lead to a degrading of the relative importance of the objectives, which I would guess is a minor communication failure.

Perhaps more to the point, there is no compensating advantage to providing interest rate guesses, at least away from (the logic of) the zero bound. When the Fed is down against the zero bound and casting about for additional means of stimulus, it can have some by taking the risk premium out of the forward rates, by providing time-based guidance, with or without caveats. So there is a benefit – in terms of stimulus – that compensates for the costs I describe above.

But when the Fed is presumably in a tightening program and is no longer trying to provide max stimulus with its conventional tool, the level of rates, then this advantage disappears. To me, that is the main point. Logically, there is no such thing as good hawkish guidance.