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January 27, 2022

Time for forward guidance: Fed should embrace the unconventional

By JOHN CORBETT | October 11, 2012

During this election season, one of the issues weighing most heavily in the minds of voters will be the state of the economy. For all that has been said of the economic plans of the two candidates, it is easy to forget that the most important actor in the financial recovery will not be on the ballot this November, and is already in the midst of executing a large-scale and unconventional policy known as quantitative easing.

This actor is the Federal Reserve. When the financial crisis began in December 2007, the Fed began to lower short-term interest rates by purchasing government bonds. The idea is that by lowering interest rates, individuals who are reluctant to borrow money and take on new investment projects will be more willing to take the risk, increasing spending and thus breathing regenerative vigor into the economy. This mechanism of influencing the economy by lowering interest rates requires an implicit assumption: interest rates are currently greater than zero. As a result of the Fed’s monetary policy since 2007, however, short-term interest rates have been lowered to nearly zero, which means that, as far as traditional approaches are concerned, the Fed is out of stimulative firepower. This is where quantitative easing comes in.

Quantitative easing refers generally to a recent innovation of monetary economists meant to exert additional stimulative force on the economy. Rather than sticking to traditional government bonds, QE includes purchasing quantities of private securities in order to impact long-term interest rates. The key distinction to understand is that of long-term versus short-term interest rates, and the reasons why long-term interest rates are what actually matter in an economic recovery. Long-term interest rates, as targeted by quantitative easing, are what the Fed needs to target because of the close relationship between consumer confidence and market health. Low short-term interest rates may be superficially appealing, but as any risk-averse borrower understands, low rates are only a boon to borrowing as long as they can be expected to remain low. Otherwise, you find yourself paying much higher interest after the expiration of low “teaser rates,” a pattern which, incidentally, was one of the major contributing factors to the firestorm of mortgage defaults that spurred the financial crisis.

So, long-term interest rates must be held low in order to accrue genuine borrower confidence. And in theory, the asset purchases that characterize QE should mean that interest rates do actually go down. However, empirical evidence has shown that asset purchases alone do not necessarily result in lower interest rates. This unexpected result can likely be explained by the role of consumer confidence in determining interest rates and other relevant economic variables. The fact is, many consumers simply don’t understand the implications of the Fed’s asset purchases through QE. They need something more concrete to signal to them that it is, in fact, safe to borrow again.

In order to address this issue, the concept of supplementing asset purchases with a clearly articulated statement of “forward guidance” has gained in popularity. Forward guidance provides consumers with the kind of signal they need to begin taking advantage of low interest rates without the fear of facing higher rates in the near future. Currently, two major approaches are available to the Fed to communicate, through forward guidance, how QE is doing.

The first method involves using the rate of inflation as the benchmark against which future QE decisions are evaluated. Inflation is a decent start, because it influences how much a person’s dollar is worth, and can theoretically be offset by lowering the cost of borrowing a dollar if the value of that dollar deteriorates. This is the stance that the Federal Reserve currently adopts when evaluating decisions to buy or sell securities.

The second uses a broader metric, nominal gross domestic product (NGDP), as a benchmark. The case for NGDP targeting rests on the fact that NGDP is the sum of two economic indicators, real GDP and inflation. Assessment of quantitative easing through the lens of nominal GDP levels gives monetary policy makers the ability to respond to changes in real economic development while also keeping an eye on inflation.

While both methods have their merits, NGDP targeting is almost certainly preferable to inflation targeting. This is true for three reasons.

The first two have to do with the inherent advantage of NGDP over inflation as a predictive factor, while the third has to do with the benefit of targeting an NGDP level rather than an inflation rate. First is the fact that NGDP already takes inflation into account. As a result, NGDP targeting allows policy makers to view economic development in aggregate, rather than looking at only one of the two elements of NGDP (inflation or real GDP). Second, the nature of economic recoveries is often such that people worry that the actions of central banks will drive up inflation and make a recovery more difficult. By not making a distinction between real growth and inflation, policy makers can focus on returning the economy to its previous levels of output without worrying excessively that its stimulative measures will erode the value of currency. Third, targeting an NGDP level is more useful than an inflation rate because it allows policy makers to retain better control of the economy from year to year. Simply put, if the Fed aims for a 5 percent growth in one year, and falls short of this by 1 percent, it can aim for a level of GDP for the following year that effectively carries the lost 1 percent over from this year to the next. This is easier to assess than the shortfall of an inflation rate in a particular year, and is also easier to achieve because it can come about from either an increase in real GDP or inflation.

Fortunately, the Chicago Federal Reserve has already shown willingness to give unconventional economic variable targeting some thought, and has discussed using a combination of unemployment and inflation judgments to monitor quantitative easing. While it is hopeful to believe that such intermediate measures will reverse the trend of declining economic growth rates over the last few months, such signals seem to suggest that a more aggressive change in policy is necessary. It is time that the rest of the Federal Reserve banks follow suit. Given a proper chance, NGDP targeting could be what our economy needs to finally stabilize itself and facilitate a more robust recovery.

John Corbett is a sophomore Economics and International Studies double major from Portsmouth, R.I.

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