August 29, 2013
Forward Guidance – Who Are You Going to Believe, the Fed or Your Lying Eyes?
Recently, a commentary published by the Federal Reserve Bank of San Francisco, “How Stimulatory Are Large-Scale Asset Purchases?”, came to my attention. In this commentary, the co-authors,Vasco Cúrdia and Andrea Ferrero, state:
“The Federal Reserve’s large-scale purchases of long-term Treasury securities most likely provided a moderate boost to economic growth and inflation. Importantly, the effects appear to depend greatly on the Fed’s guidance that short-term interest rates would remain low for an extended period. Indeed, estimates from a macroeconomic model suggest that such interest rate forward guidance probably has greater effects than signals about the amount of assets purchased.”
Cúrdia and Ferrero (C&F), similar to so many of their mainstream brethren, believe that the degree of aggregate-demand stimulation emanating from Fed purchases of long-maturity securities depends on the degree of decline in yields on long-maturity securities resulting from these purchases. But C&F argue that Fed purchases of long-maturity securities alone sow the seeds of their own ineffectiveness in stimulating aggregate demand. According to C&F, any initial decline in yields on long-maturity securities will quickly be offset by a subsequent rise in yields as market participants revise their expectations for an earlier Fed-induced increase in the federal funds rate and/or a larger increase in the federal funds rate due to stronger growth in nominal demand resulting from the Fed’s purchases of longer-maturity securities. Got that? So, according to C&F, if Fed purchases of long-maturity securities are going to be more effective in stimulating aggregate demand, the Fed needs to provide forward guidance as to at a minimum, when it intends to begin lifting the federal funds rate.
Before I comment on “forward guidance” as a monetary policy tool, let me once again provide you with my explanation of how Fed purchases of securities, long- or short-maturity, it does not matter, stimulate aggregate spending. The Fed purchases a security from me. The funds that I receive from the Fed did not come from you or anyone else. The funds came from the Fed’s figurative printing press. These are net new immediately spendable funds in the economy. It is as if these funds were created out of thin air. I have three options with which to use these funds. Option One would be for me to spend these funds to purchase goods, services or assets, including financial assets. Option One directly increases nominal spending. Option Two would be for me to lend these funds to someone else. Most people borrow funds to spend them on something – a good, a service or an asset, including a financial asset. So, Option Two indirectly increases nominal spending. Option Three would be for me to simply hold these funds at my bank. If my bank is unable to use these funds to acquire any new earning assets, perhaps because of capital constraints, then Option Three would not result in any new nominal spending in the economy. Other than extreme risk aversion, it is difficult for me to rationalize persisting with Option Three for any length of time. Although yields may be gyrating all over the place for all kinds of reasons after the Fed engages in purchases of securities, to me the effect on nominal aggregate demand from Fed purchases of securities boils down to if Bernanke prints it, someone will spend it.
Alright, let’s get on to forward guidance. Suppose the economy has been dead in the water and the federal funds rate is fallen to zero. Under these conditions, the Fed states that it has no intention of lifting the federal funds rate in the coming x-number of months. This “forward guidance” with regard to the Fed’s target of the federal funds rate is quite credible. Why would anyone expect the Fed to raise the federal funds rate so long as the economy is “in irons” (hint – it is a sailing term)?
A few months pass and the economy remains moribund. In response, the Fed begins a program of securities purchases, with Options One and/or Two, as discussed above, being operative. That is, nominal spending begins to grow faster. At the same time, the Fed reiterates its statement that it has no intention of lifting the federal funds rate in the coming x-number of months. Is the Fed’s same forward guidance as credible now, after the implementation of its program of securities purchases and after tangible evidence of a pick-up in nominal spending? If it is to you, I have some bonds I want to sell you.
The Fed can provide all of the forward guidance it wants. But if its actual policy actions, in contrast to its words, and the incoming economic evidence suggest that a prudent monetary policy should run counter to the Fed’s forward guidance, who are you going to believe – the Fed or your lying eyes? After years of observing the behavior of financial markets, I bet that you are going to conclude that your eyes are not lying and that you will make portfolio adjustments accordingly. After you and other market participants have altered your portfolios in accordance with reality, the Fed will eventually will alter its guidance.
Paul L. Kasriel