Brookings Papers ON ECONOMIC ACTIVITY

BROOKINGS INSTITUTION PRESS

Contents

Editors' Introduction..............................................................................................................................................viiJEFFREY R. CAMPBELL, CHARLES L. EVANS, JONAS D. M. FISHER, and ALEJANDRO JUSTINIANO Macroeconomic Effects of Federal Reserve Forward Guidance.....................1JAMES H. STOCK and MARK W. WATSON Disentangling the Channels of the 2007–09 Recession........................................................................81JAY C. SHAMBAUGH The Euro's Three Crises..........................................................................................................................157J. BRADFORD DELONG and LAWRENCE H. SUMMERS Fiscal Policy in a Depressed Economy...................................................................................233KAREN DYNAN Is a Household Debt Overhang Holding Back Consumption?................................................................................................299ERIC CHANEY Democratic Change in the Arab World, Past and Present.................................................................................................363

Chapter One

CHARLES L. EVANS Federal Reserve Bank of Chicago

JONAS D. M. FISHER Federal Reserve Bank of Chicago

ALEJANDRO JUSTINIANO Federal Reserve Bank of Chicago

Macroeconomic Effects of Federal Reserve Forward Guidance

ABSTRACT A large output gap accompanied by stable inflation close to its target calls for further monetary accommodation, but the zero lower bound on interest rates has robbed the Federal Open Market Committee (FOMC) of the usual tool for its provision. We examine how public statements of FOMC intentions—forward guidance—can substitute for lower rates at the zero bound. We distinguish between Odyssean forward guidance, which publicly commits the FOMC to a future action, and Delphic forward guidance, which merely forecasts macroeconomic performance and likely monetary policy actions. Others have shown how forward guidance that commits the central bank to keeping rates at zero for longer than conditions would otherwise warrant can provide monetary easing, if the public trusts it. We empirically characterize the responses of asset prices and private macroeconomic forecasts to FOMC forward guidance, both before and since the recent financial crisis. Our results show that the FOMC has extensive experience successfully telegraphing its intended adjustments to evolving conditions, so communication difficulties do not present an insurmountable barrier to Odyssean forward guidance. Using an estimated dynamic stochastic general equilibrium model, we investigate how pairing such guidance with bright-line rules for launching rate increases can mitigate risks to the Federal Reserve's price stability mandate.

From the onset of the financial crisis and through the Great Recession and ensuing modest recovery, the Federal Open Market Committee (FOMC) of the Federal Reserve has commented upon the likely duration of monetary policy accommodation in the formal statement that follows each of its meetings. In December 2008 it said, "The Committee anticipates that weak economic conditions are likely to warrant exceptionally low levels of the federal funds rate for some time." In March 2009, when the first round of large-scale purchases of Treasury securities was announced, "an extended period" replaced "some time" in the formal statement. The August 2011 FOMC statement gave specificity to "an extended period" by announcing that the committee expected the funds rate to remain exceptionally low until "at least ... mid-2013." The January 2012 statement lengthened the anticipated period of exceptionally low rates even further, to "late 2014," language that remained in the March 2012 statement. Such communications of monetary authorities' intentions are referred to as forward guidance.

The nature of this most recent forward guidance by the FOMC is the subject of substantial debate. Studies by Paul Krugman (1999) and by Gauti Eggertsson and Michael Woodford (2003) before the recent episode and by Iván Werning (2012) more recently suggest that a monetary policymaker encountering the zero lower bound (ZLB) on the policy interest rate can stimulate current aggregate demand by credibly promising to keep the rate at zero longer than required by economic conditions and thereby creating an economic boom in the future. One might interpret "late 2014" as such a credible promise, but one also might interpret it as merely describing what the FOMC's policy reaction function would prescribe if current forecasts of sluggish economic activity and low inflation through that date come to pass. "Late 2014" predicts unusually accommodative policy whenever the underlying policy reaction function would dictate an earlier "liftoff" of the funds rate from zero given the identical conditioning data.

Motivated by these competing interpretations of "late 2014," we distinguish between two kinds of forward guidance. Delphic forward guidance publicly states a forecast of macroeconomic performance and likely or intended monetary policy actions based on the policymaker's potentially superior information about future macroeconomic fundamentals and its own policy goals. Such forward guidance presumably improves macro economic outcomes by reducing private decisionmakers' uncertainty. Importantly, however, it does not publicly commit the policymaker to a particular course of action. Odyssean forward guidance, in contrast, does publicly commit the policymaker, just as Odysseus committed himself to staying on his ship by having himself bound to the mast. Tying one's hands in the face of an uncertain future might seem like a foolish sacrifice for no apparent gain, but economic fluctuations routinely present opportunities for monetary policy to benefit from issuing Odyssean forward guidance. The reason is that by so doing, policymakers can change public expectations of their actions tomorrow in a way that improves macroeconomic performance today.

Nevertheless, the implementation of Odyssean policy faces a fundamental challenge. When the appointed time for action arrives, any beneficial effects of the policy's anticipation will be bygones that nothing can change. Therefore, both the monetary policymaker and the public will at that later time prefer a policy that addresses only the present circumstances and ignores the beneficial effects of its anticipation on past macroeconomic performance. For example, when it comes time to keep an earlier promise to raise aggregate demand, the FOMC will be concerned about its price stability mandate and, acting as it has always done in normal times, will not want to follow through. Just as Odysseus anticipated that on hearing the Sirens' song he would regret his commitment to stay aboard his ship, so might monetary policymakers anticipate regretting their commitment to ease policy. If the public understands this and therefore believes that such promises will not be kept, they will not have the intended effect. Odysseus could use the rope that bound him to the mast to enforce his commitment. Lacking such an enforcement mechanism, monetary policymakers must rely on their reputations for accuracy and honesty to make their commitments credible.

The Odyssean monetary policies elucidated by Krugman, Eggertsson and Woodford, and Werning have inspired several recent proposals to provide more accommodation at the ZLB. The more aggressive policy alternatives that have been proposed include Evans's (2012) state-contingent price-level targeting, nominal income targeting as advocated by Christina Romer, and conditional economic thresholds for exiting the ZLB as proposed by Evans (2011). The main challenge facing the FOMC in implementing any of these policies is convincing the public that it will follow through on the promised future course of action. This paper sheds light on the FOMC's ability to meet this challenge and on the possible benefits of doing so.

The FOMC has used forward guidance implicitly, through speeches and testimony by its members, and explicitly, through formal committee statements, since long before the financial crisis, so the question of whether the FOMC can clearly communicate its future policy intentions can be addressed empirically. Accordingly, the first part of this paper examines data from before and after the crisis, to measure the impact that FOMC communications have had on private expectations. We begin by studying market responses to FOMC statements, building on prior work by Refet Gürkaynak, Brian Sack, and Eric Swanson (2005). Those authors follow Kenneth Kuttner (2001) by analyzing changes in prices on federal funds rate futures in short windows of time surrounding the release of FOMC statements. Using a sample from June 1991 through December 2004, Gürkaynak and his coauthors find that FOMC statements are associated with significant effects, both on federal funds futures prices and on Treasury yields, that are not due to surprise changes in the federal funds target itself. That is, their results show that market participants believe that FOMC statements contain reliable information about future monetary policy actions. We verify that these findings continue to hold when the sample is extended to July 2007, just before the crisis.

One might doubt the relevance of these findings for the present situation, because the attainment of the ZLB has robbed the FOMC of its principal policy lever. But evidence exists that the FOMC can still exert influence in the presence of a binding ZLB. Focusing on FOMC communications about its recent large-scale asset purchases, known as QE1 and QE2, Joseph Gagnon and coauthors (2010) and Arvind Krishnamurthy and Annette Vissing-Jorgensen (2011) provide evidence of significant asset price effects since the crisis. To complement these studies and provide more assurance that forward guidance unaccompanied by material policy action can move asset prices, we apply Gürkaynak and his co authors' methodology to FOMC statements since the crisis and find results similar to theirs.

FOMC actions that influence asset prices are merely means toward the end of fulfilling the Federal Reserve's dual mandate of maximum sustainable employment and price stability. To evaluate the contributions of FOMC statements toward this ultimate goal, we examine how revisions to the Blue Chip consensus forecasts of the unemployment rate and consumer price index (CPI) inflation respond to the policy innovations identified by Gürkaynak and others (2005). For the sample period February 1994 to June 2007, a positive innovation to future federal funds rates is associated with decreases in unemployment forecasts for the subsequent 3 quarters and with higher forecasts of CPI inflation in the current and subsequent quarters. We never find a statistically significant reaction of either forecast that is of the "correct" sign, that is, one that indicates a New Keynesian response to an exogenous policy shock. From this we conclude that the monetary policy surprises identified with high-frequency data have a substantial Delphic component, despite the fact that the methodology of Gürkaynak and others inherently controls for publicly known macroeconomic fundamentals. That is, professional forecasters infer that the FOMC's unexpected policy adjustments are responses to nonpublic information that the FOMC possesses regarding the future strength of the economy. We find qualitatively similar results for the crisis period, but the estimates are too imprecise to allow firm quantitative conclusions.

The FOMC does not rely solely on postmeeting public statements to communicate its policies. To get a broader perspective on the influence of FOMC communications on private expectations, we proceed to examine monetary policy surprises identified from a simple interest rate rule like those of John Taylor (1993, 1999) and David Reifschneider and John Williams (2000). Using the Blue Chip forecasts and interest rate futures prices aggregated to the quarterly level, we estimate such a rule and decompose its residual into the part revealed when the spot policy rate is set and the parts revealed to the public in the prior 4 quarters.

We highlight here four results based on data from 1996 through 2007. First, the standard deviation of the expected interest rate 4 quarters out minus its value from the rule is only 9 basis points (bp). Thus, the rule describes medium-run forecasts of FOMC behavior extremely well. Apparently, the FOMC has been successful in communicating its typical behavior to the public. Although this need not reflect an Odyssean commitment, it is observationally equivalent to one. Second, the FOMC telegraphs 40 percent of its deviations from the interest rate rule exactly 1 quarter in advance and another 40 percent 2 or more quarters in advance. Third, the identified forward guidance residuals have much stronger effects on asset prices than do surprises of the type described by Gürkaynak and others (2005). For example, a 1-bp innovation to next quarter's expected federal funds rate moves both the 2-year and the 5-year Treasury rate by about 2 bp. The corresponding effects estimated with the methodology of Gürkaynak and others are under 1 bp. Fourth, the identified forward guidance residuals are negatively correlated with unemployment forecast revisions and positively correlated with inflation forecast revisions, just like the statement date–based shocks in Gürkaynak and others (2005). Apparently, the residuals reflect, at least in part, anticipated deviations from the policy rule that nevertheless are motivated by recent news of economic fundamentals. Phrased differently, the FOMC's behavior has been history dependent: the committee reacts more aggressively to economic weakness revealed only shortly before its onset than to weakness foreseen 4 quarters in advance.

The estimated effects of FOMC forward guidance on asset prices and private forecasts suggest that the FOMC has had some success in communicating its future intentions to the public. This suggests that communication difficulties do not present an insurmountable barrier to monetary policy based on Odyssean forward guidance. The second part of our paper investigates the consequences of interpreting the "late 2014" statement language as Odyssean forward guidance that implements the policy recommendations of Eggertsson and Woodford (2003) and others. There are legitimate concerns that forward guidance of this kind places the FOMC's mandated price stability goal at risk. We consider these concerns by forecasting the path of the economy with the present forward guidance and subjecting that forecast to two upside risks: higher inflation expectations and faster deleveraging by households and firms.

This policy analysis uses a medium-scale dynamic stochastic general equilibrium (DSGE) model adapted from Justiniano, Giorgio Primiceri, and Andrea Tambalotti (2011) at the Federal Reserve Bank of Chicago. The model strongly resembles other medium-scale DSGE models in the literature and is very similar to models used at central banks around the world. Importantly for our purposes, it embodies the basic mechanisms that make forward guidance attractive at the ZLB.

Evans (2011) has proposed that the FOMC pledge to begin lifting its policy rate from zero if either the unemployment rate falls below 7 percent or expected inflation over the medium term rises above 3 percent. This "7/3" threshold rule is designed to maintain low interest 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 FOMC's 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 deleveraging observed since the financial crisis.

I. FOMC Statements and Private Expectations

The FOMC's use of forward guidance since long before the financial crisis makes it possible to assess empirically its ability to communicate its future policy intentions. In this section we do so by applying the methodology of Gürkaynak, Sack, and Swanson (2005; GSS henceforth). They use high-frequency data on prices of federal funds futures and Eurodollar futures contracts to measure unanticipated changes in expected future spot interest rates associated with FOMC statements. Two estimated factors, a target factor that moves the current policy rate and a path factor that moves only expected future rates, account for most of these changes. GSS show that yields on longer-duration Treasury notes respond substantially to the path factor.

We extend the GSS analysis in three ways. First, we examine the responses of yields on corporate bonds to the factors and confirm that a positive realization of the path factor raises not only expected future policy rates but corporate borrowing rates as well. That is, forward guidance influences interest rates that are directly relevant for private investment decisions. Second, we examine how revisions to professional forecasts of unemployment and CPI inflation respond to the factors. If the public and the FOMC were equally well informed about macroeconomic fundamentals, then the factors must reflect the revelation of FOMC policy preferences. In that case one would expect forecast revisions to match the equilibrium response to an unanticipated monetary policy shock. Instead, however, we find that the statistically significant responses all have the sign opposite to that predicted by the standard New Keynesian model: unanticipated increases in the path factor lead to decreases in expected unemployment and increases in expected inflation. From this we conclude that professional forecasters believe that FOMC policy surprises contain useful and otherwise unavailable macroeconomic information—that is, they have a Delphic component. Third, we extend the sample period so as to examine FOMC announcements since the onset of the financial crisis in August 2007. Here the relatively small sample makes our estimates of professional forecasters' responses to surprise monetary policy moves too imprecise to allow firm conclusions, but the estimates of asset price responses remain accurate enough to show that they differ little from their precrisis values.

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