Janet Yellen has been closely involved in designing Federal Reserve policy, so don’t expect any radical departures when she takes over as chairman from Ben Bernanke next year. That’s fine: No radical departure is necessary. Bernanke’s Fed has done a good job under difficult circumstances -- made even more difficult by the mess that Congress has made of fiscal policy.
Still, there’s room for improvement on the presentation of policy, and that’s an issue in which Yellen has already taken a particular interest. Starting with her Senate testimony this week, she’s about to be tested on it much more minutely.
The subject is tricky because the common-sense distinction between policy and the presentation of policy doesn’t work in monetary affairs. Because expectations of inflation and interest rates play such a vital role in driving the economy, substance and presentation are really one and the same. Whether the Fed means to or not, it can change monetary conditions, in effect tightening or loosening policy, by changing the way its intentions are understood.
Lately, central banks have had to worry about this a lot. When interest rates are close to zero, there’s no conventional way to ease monetary policy any further. One option is to be unconventional, using new policy instruments such as quantitative easing. Another is to change expectations -- for instance, by promising to keep interest rates at zero for longer than investors would otherwise have deemed likely. Under Bernanke and Yellen, the Fed has tried both.
The evidence suggests that QE has worked, though with gradually diminishing effectiveness. But the record of “forward guidance” -- the effort to manage expectations -- isn’t so good. An underlying contradiction explains why.
At one extreme, the Fed can simply affirm the interest-rate expectations that investors have already formed on the basis of consensus forecasts and the central bank’s stated goals of low inflation and full employment. But that’s no use: Just telling the market what it already knows doesn’t provide new stimulus.
At the other extreme, the Fed could aim to change the market’s beliefs, either with forecasts that differ from the market consensus or by altering its goals (for example, by saying it will let inflation rise above target and stay there). Either of these could provide new stimulus, but only by calling the central bank’s credibility into question. Investors won’t accept outside-the-consensus forecasts just because the Fed tells them to. And a weaker commitment to keep inflation low is, in effect, a promise to be irresponsible (as Paul Krugman has put it). No central banker wants to be seen as irresponsible.
It’s quite a dilemma -- and at the moment, the Fed is trying to have it both ways. For stimulus purposes, it wants the market to believe that it will keep interest rates low for longer than investors would otherwise have calculated. For credibility purposes, it wants its inflation and output forecasts to align with those of investors and its policy goals to be seen as essentially unchanged.
That doesn’t add up, and the result is the confusion that markets have expressed in recent months. The inability of the Fed’s governors to agree among themselves about prospects, goals and instruments only makes this confusion worse.
You can disguise the underlying contradiction by making forward guidance ever more complicated -- the Bank of England is currently the pioneer in this endeavor, and Yellen may be of a mind to do the same -- but you can’t resolve it. Either you change the policy goals or you accept that forward guidance has little force. Deny the contradiction too strenuously, in fact, and you end up with the worst of all worlds: no additional stimulus, extra confusion and instability, diminished credibility.
There’s a respectable case for changing the Fed’s goals and explicitly adopting a softer stance on inflation -- one that allows for persistent overshoots of the 2 percent target after bad recessions. You could put such a system into effect by adopting a target for the future path of the price level or for the level of nominal gross domestic product. These ideas have a lot of academic support, but I’m unconvinced. Whatever the theoretical pros and cons, Yellen is unlikely to go there, and she would meet intense political resistance if she tried.
Given that, I’d recommend a greater emphasis on simplicity. With inflation well suppressed and plenty of slack in the labor market -- hence no upward pressure on wages -- the Fed’s existing mandate easily justifies keeping interest rates at zero, plus quantitative easing until further notice. One could simply leave it at that. Enough said.
However, in the same spirit of simplicity, let me offer another refinement. Without setting a long-term target path for the level of NGDP, the Fed could talk more about its intentions for near-term changes in NGDP.
What’s the difference? The first approach, as I’ve said, announces a willingness to let inflation persistently overshoot its target. Whether this makes sense or not, it recasts the Fed’s dual mandate in a profound way. The second approach is far more timid -- merely recognizing that in the short term the Fed controls aggregate demand (measured by NGDP) but cannot fix the way extra demand divides between higher output and higher prices.
Casting monetary policy in terms of a short-term projection for growth in NGDP is a profession of modesty, not of radical intent. It implies tolerance of brief inflation overshoots, but it’s consistent with the basic inflation-target framework that central bankers -- including Yellen, most likely -- feel politically constrained to apply.
So if Yellen wants to innovate -- and what new leader doesn’t? -- here’s how. Projections of growth in NGDP one or two years ahead offer a simpler, clearer way to frame and explain the policy she and Bernanke have already devised. This is better than the alternative the Fed has favored so far. Increasingly detailed rules about when to taper QE (maybe) or start thinking about higher interest rates (unless something we haven’t thought of happens) just don’t help.
(Clive Crook is a Bloomberg View columnist.)
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