Wednesday, June 13, 2012

The Whole is Greater than the Sum of its Parts: Forward Guidance and QE

Maybe interest rates aren't so useless after all

In a recent post from Stephen Williamson, he derides Christina Romer's proposal to tie new monetary expansion to objectives such as unemployment or inflation
First, I'm not sure how you announce a policy without saying what it is. Second, the last sentence in the above quote is interesting. The Fed claims that, for example, purchases of long-maturity Treasuries will lower long bond yields. If they were confident about that, the FOMC would announce targets for long bond yields rather than quantitative goals. They don't announce the targets, therefore they must not be confident that QE does what they claim.
My first reaction is the classic Market Monetarist/Friedman/Bernanke retort: interest rates aren't an indicator for the stance of monetary policy. Perhaps the Fed lowering the interest rate could be an example of loosening policy, but it would hardly qualify as loose policy. In a sense, the derivative of the interest rate time path could give information about the derivative of the policy tightness function, but the level of the interest rate tells you nothing about the tightness of policy. Low interest rates could reflect low NGDP expectation or they could reflect substantial levels of monetary easing. There's no way to actually tell.

However, some recent econometric evidence has shown the forward guidance on interest rates has some effect. In the conference paper "Macroeconomic Effects of FOMC Forward Guidance," the authors categorized two kinds of forward guidance: Odyssean and Delphic.

In Odyssean forward guidance, the interest rate path is a path that will take place in spite of elevated inflation or NGDP. The declared interest rate path is a deviation from the policy rule and is designed to "catch up" to trend growth. On the other hand, Delphic forward guidance is simply a prediction. The interest rate path is simply following the policy rule and will not make any exceptional effort to catch up growth. Thus, if the Fed's commitment to low interest rates until at least mid-2013 is Odyssean, it means that the Fed sees NGDP growth rising but it will still commit to low rates. If the guidance is merely Delphic, the guidance is merely a forecast of low NGDP growth until at least mid-2013.

(Note:  Odyssean references the scene in the Odyssey, when Odysseus commands his sailors to tie him to the mast of the boat when they travel through the land of the sirens. Odysseus committed, beforehand and contrary to what he would want at the time, to stay tied to the boat. Delphic refers to the oracle of Delphi that could tell the future.)

In the period of time before the financial crisis, research showed that the markets were listening to the Fed's declarations for a future policy path. As summarized in the Brookings paper (note, GSS is the name of the study that analyzed the data, my emphasis)

By performing a suitable rotation of the two unobserved factors, GSS show that they can be given a structural interpretation. One is a “target” factor, corresponding to surprise changes in the current federal funds target. The other is a “future path of policy,” or simply “path,” factor, corresponding to changes in futures rates that are independent of changes in the current funds rate target. The “path” factor is shown to be associated with significant changes in FOMC statement language. For example, its largest realization in absolute value occurs on January 28, 2004 when the federal funds target was not changed, but the phrase “policy accommodation can be maintained for a considerable period” was replaced with “the Committee believes it can be patient in removing its policy accommodation.” This change in language was interpreted by markets as indicating the FOMC would begin tightening policy sooner than previously expected. 
Using ordinary least squares regressions of changes in interest rates before and after the windows of time surrounding FOMC statements on the target and path factors they find that 75 to 90 percent of the explainable variation in five- and ten-year Treasury yields is due to the path factor rather than to changes in the federal funds rate target itself. Information in the statement about the future funds path that differs from prior market expectations or revelations about the FOMC’s outlook for the economy that changes private expectations of that outlook both should affect anticipated future federal funds rates. Therefore their evidence strongly suggests that forward guidance, broadly conceived, has had an impact on asset prices prior to the financial crisis.
The zero-lower bound has called into question whether interest rate guidance can still stay effective. The current literature on QE1 and QE2 both use this "future path of policy" argument. As per the paper:
This evidence is suggestive for the current situation, but not conclusive, since it covers a period before the financial crisis and the attainment of the ZLB robbed the FOMC of its principal policy tool. Research on monetary policy announcements since the onset of the crisis has focused almost exclusively on the impact of announcing large scale asset purchases (LSAPs).7There is significant evidence that LSAP policies can alter long-term interest rates. For example, Gagnon, Raskin, Remache, and Sack (2010) present an event study of QE1 that documents large reductions in interest rates on dates associated with announcements of LSAPs. Also using an event-study methodology, Krishnamurthy and Vissing-Jorgensen (2011) evaluate the impact on interest rates of announcements associated with both QE1 and QE2. They uncover several channels through which these announcements have had an impact on asset prices. With QE2 a major role is ascribed to a “signalling” channel whereby financial markets interpreted LSAPs as signalling lower federal funds rates going forward. This suggests that one feature of LSAPs resembles forward guidance and so the findings of Krishnamurthy and Vissing-Jorgensen (2011) can be interpreted as supporting the view that forward guidance has had a significant impact in the recent period. However, the impact of “pure” forward guidance, where the policy action is solely reflected in statement language, in the recent period remains unclear.
More rigorous statistical analysis finds that the path factor still exerts a large amount of impact. 

When the target and path factors are calculated using all the announcements in Table 1 except the one associated with QE1 they explain 96 percent of the total variation in the seven futures contracts we employ for their estimation. The target factor alone explains 79 percent of the variationTable 2 reports the fraction of variation in each of the seven futures contracts explained by each of the two factors. The target factor dominates the variation in the current quarter futures rate and the one-, two- and three-quarter ahead rates, while the path factor explains the majority of variation in the three longer rates and negligible share of the two shortest contracts after the current quarter one. This pattern is broadly similar to the one obtained by GSS. The main differences are that in our case the target factor accounts for a somewhat larger share of variation at the short end, while the path factor’s explanatory power is more concentrated toward the long end. Still, the overall impression is that the impact of FOMC statements in the recent period is not very different from prior to the financial crisis. Given the disparity in the associated economic conditions this is a striking finding.
So, to quibble with Nick Rowe, the impact of the future path of interest rates is probably not 99%, but the effect is still very high.

There is also some interesting information on the safe-assets story in the paper. The authors find that expansionary forward guidance can lower corporate bond yields. Specifically:

In contrast, a one-standard deviation positive path factor realization raises the Aaa yield by 54 basis points and the Baa yield by 48 basis points.

This provides evidence of a portfolio balance effect that QE does stimulate easier credit conditions for firms. Yet this effect comes not so much from the actual asset purchases but rather from the information on the path of future policy that it yields.

As a result of this forward guidance analysis, the paper finds the Evans 7% unemployment/3% inflation joint target useful to restore aggregate demand without destabilizing inflation expectations:
Evans (2011) has proposed conditioning the FOMC's forward guidance on outcomes of un-employment and inflation expectations. His proposal involves the FOMC announcing specific conditions under which it will begin lifting its policy rate above zero: either unemployment falling below 7 percent or expected inflation over the medium term rising above 3 percent. We refer to this as the 7/3 threshold rule. It is designed to maintain low rates even as the economy begins expanding on its own (as prescribed by Eggertsson and Woodford(2003)), while providing safeguards against unexpected developments that may put the FOMCs price stability mandate in jeopardy. Our policy analysis suggests that such conditioning, if credible, could be helpful in limiting the inflationary consequences of a surge in aggregate demand arising from an early end to the post-crisis deleveraging.
Thus, the econometric evidence comes somewhere in the middle. Yes, interest rate guidance can have an effect, but asset purchases have a large impact as well on a wide variety of interest rates because the purchases substantively change the expected future path of policy. This suggests that the two policies together would have a much stronger effect than either of them apart. I see this playing out in the following manner: 

Limiting policy to a near-term interest rate commitment raises the possibility that the forward guidance describes the Fed passively tightening and keeping growth down. This forward guidance may be seen as Delphian. However, with asset purchases like QE, the Fed signals that it is committed to expansionary policy, which has first order effects on corporate bond yields and other asset prices. This additional policy action changes the original forward guidance from being Delphian to Odyssean. The Fed will be effectively saying, "We will pursue asset purchases that will push up inflation, but in spite of this inflation we will be keeping interest rates low". This would break out of the indeterminacy on whether low interest rates are expansionary or contractionary. Quantitative easing might be normally seen as just a temporary injection of money, but forward guidance cements that injection in as permanent.

This interaction effect would offer the Fed much more ammunition with its current policies. It could help alleviate the concerns of the "concrete steppes" by using not-so-unconventional policies to shape expectations. Once the expectations are settled and we escape the zero-lower-bound, forward looking monetary policy shouldn't be too difficult at all. This would be an example of the pragmatic monetary policy that could eventually transition to the end of history stabilization policy: a NGDP targeting regime.

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