A New Strategy for the Fed
I've been putting a great amount of time and thought into a big project on monetary policy -- about which, more details in a few weeks -- but let me share this one part of it as an essay. What has interested me is the Fed's apparent difficulty communicating the way it anticipates to tighten monetary policy over the next five years conditional on economic performance and outlook.
And then see this slide from Evans' talk today:
This stuff is straight Woodford and Svensson, applied to the Fed's own mandate and macroeconomic model FRB/US. This is not at all how the Fed has communicated in the past, but it is how the two academic economists have long wanted it to. They suggest making the loss function explicit, and it's a different approach from nominal GDP targeting -- where the single-term loss function would be the discounted squared sum of deviations in NGDP growth, naturally -- but the implied path of monetary policy is basically the same.
So I'm thrilled that the intellectual leaders of the Fed's communication policy -- Yellen, who runs the FOMC's subcommittee on it, and Evans, who came up with the rule -- have realized that loss functions and optimal control theory really are how you ought to think about monetary policy. And the sooner this framework begins influencing forward-guidance language, the better.
How would it do that, exactly? Here is where I come in with my recommendations. What the Fed has tried to do with forward guidance over the last year is plot the possible paths of the policy rate conditional on economic scenarios, but the way they've been doing it is kludgey when you think about it. We've been talking about asset purchases and signaling future policy -- and signaling is imperfect! -- so much that we've forgotten that there is a way to do this more directly.
My recommendation is that the Fed should target federal funds rate futures, eurodollar futures, overnight indexed swap (OIS) rates, or an appropriate proxy for the expectation of future interbank lending rates. (Whatever the specific contract form, I'll call them fed funds futures going forward.) The reason why it ought to do this: There's nothing clearer than just talking about the actual course of policy directly.
Here's how this would work. The FOMC concludes its next full meeting in mid-December. In the summary of economic projections, the Fed should report what fed funds futures prices it believes to be warranted given the midpoint of the central-tendency projection over some five-year curve. It should also report the fed funds futures prices warranted conditional upon upward or downward deviations in economic data from the midpoint of the central-tendency projection. In other words: If we get ugly or nice surprises, how does the Fed plan on changing plans?
My sense is that would be enough to send fed funds futures wherever the Fed wanted them. Why? Because the Fed sets the target federal funds rate, so they have effective control over the futures price already. Banks would arbitrage this market heavily if the prices didn't converge. Note that they wouldn't necessarily go to wherever the Fed's central-tendency projection said they should, as the market has its own prior on the likelihood of different economic conditions.
But let's suppose that fed funds futures prices shrug off the Fed. How should the Fed respond to that? It should buy or sell fed funds futures until it pushes the prices where it wants them. That will transmit itself into other interest rates just as the targeting of the federal funds rate does. Another reason why it should do this is because the value of Fed assets would rise if the market doubted its commitment but then the Fed came through.
Suppose, for example, that the Fed thinks fed funds futures contracts for 2016 are undervalued -- as it suggests is pretty much the case right now -- that is, they imply a sharper increase in the federal funds rate than the Fed desires. If, after the Fed states its fed funds futures targets, the market says "that's just, like, your opinion, man" and implies the Fed will renege on its easy-money promise by tightening early, then the Fed should buy as much in fed funds futures as it takes. If the Fed follows through as promised, then it pockets the capital gains and passes them to the U.S. Treasury. If it reneges, it pays the market a de-facto fine.
Let's emphasize, though, that the main policy change is simply that the Fed talk explicitly about the appropriate pricing of its futures contracts.
Another benefit to targeting fed funds futures is that the Fed's current strategy -- buying up long-term Treasury debt -- is suboptimal. In particular, it has inspecific objectives, isn't really in the Fed's control, and faces a severe knowledge problem. Let's take each of those objections one-by-one. Inspecific objectives: Has the Fed told anyone how far it wanted to depress long-term interest rates? What it wanted the yield curve to look like? No, it hasn't. Out of control: The Fed sets monetary policy, not fiscal policy. Other factors also affect the yield on long-term Treasury debt beyond the supply and demand for money. Knowledge problem: Does the Fed believe it knows what the appropriate term premium is? What about the sovereign-risk premium? I'm not hearing answers. It really doesn't have to make any of these assumptions when it comes to the federal funds rate, and the equivalent security to target future policy isn't long-dated Treasuries, it's fed funds futures.
Keep in mind that this strategy is a far more conservative method of forward guidance than prior asset-purchase methods. Conservative is not to say ineffectual, but rather more consistent with the policy regime. It's not that big an intellectual leap to say that if the Fed is targeting an interbank lending rate at the present, it ought to target the same variable's expected future values. Lowering expectations of future fed funds rates would also depress longer-term lending rates, given that long rates can be thought of as the sum of short rates over the loan period.
The Fed is abuzz with communications strategies. Governor Jeremy Stein had what I thought was an interesting but ultimately undesirable recommendation to taper by some fixed amount with every 0.1-percentage-point drop in the unemployment rate. The unemployment rate's measurement error is larger than that, and you don't want to respond to noise, and structurally the unemployment rate is giving a much healthier picture of labor markets than any other measure.
I've put a lot of thought into these issues. Where I end up is that trying to explicitly tie tapering and rate hikes on incremental changes in economic data isn't a good idea. The difference between unemployment in your model and unemployment as measured in statistical reality becomes too significant. Where I end up, also, is that the strategy of buying Treasuries and mortgage-backed securities strategy is pretty imperfect. Where I end up is that there are good and bad ways to be specific in your monetary commitment and forward guidance, but there's no good way to be vague or to not commit. My sense is that targeting fed funds futures would be most consistent with conventional monetary policy -- in fact, it would fit well within the normal regime -- and would be the best way to make the conditional monetary commitments necessary to to ensure a healthy economic recovery.