Evan Soltas
Sep 4, 2015

Wake Me Up When September Ends


Does it matter exactly when the Federal Reserve raises its policy rate for the first time? Should it be September, December, or maybe even 2016?

Financial markets seem to think that call matters. And it's not just the overwhelming volume of analysis coming from the financial media. It's actually the markets themselves. Most notably, the ten-year yield has moved closely with expectations of the first rate hike as measured by futures contracts in the federal-funds market, where the Fed's target should matter most.

It's a bit surprising, then, to see economists argue that it shouldn't matter. Alan Blinder, for instance, wrote that the importance of the first hike had been "oversold." His argument is pretty reasonable. The choice is over 25 basis points higher or lower for several months at most. There's not a macroeconomic model out there which would tell you such a policy decision would have a significant economic impact. It's better to focus on the exit path over the longer term, Blinder and others have said, which really should matter.

Nevertheless, like Tim Duy, I think this perspective misses the mark. To quote Duy:

The lack of consensus regarding the timing of the first hike tells me that we don't fully understand the Fed's reaction function and, importantly, their confidence in their estimates of the natural rate of unemployment. The timing of the first hike will thus define that reaction function and thus send an important signal about the Fed's overall policy intentions.
Right. When the central bank has private information about its long-run target for the policy rate and gives a care about how its actions effect or disturb the bond market, as former governor Jeremy Stein showed in a recent paper with Adi Sunderam, it gets stuck in a bind.

Here's how the problem works, as per Stein and Sunderam. Say the central bank decides internally that its long-term target for the policy rate is too low. Because the central does not want to shock the bond market with a big change, it moves gradually. But markets aren't stupid. Understanding policy inertia, they infer from small moves in the short run what will happen in the longer run. As a result, the effort to avoid shocking the bond market doesn't work, essentially because a small hike today has more informational content about future hikes. The central bank becomes trapped by its own inertia rather than doing what it thinks would be best for the economy.

It's a brilliant insight, one that should be as influential as similar time-inconsistency arguments about inflation have been from Finn Kydland, Ed Prescott, and Ken Rogoff. And it poses an intellectual problem for the "wake me up when September ends" crowd, because a 25-basis-point hike in September isn't just a one-off decision, but one that is informative about years of potential actions down the road.

What, then, is the Fed to do about Stein and Sunderam's trap? They might recommend that the Fed should clarify that it really doesn't care if the bond market gets surprised every now and then. Another suggestion that comes out of their paper is that the Fed should try to water down its own forward guidance so that policy is less anchored by them and markets are less confident in future policy and, as a result, less susceptible to surprise. It could, for example, just kill the so-called "dot plot," in which FOMC members state their expectations for future interest rates. Or it could axe the primary dealer survey, in which the Fed's market-makers opine on what they expect the Fed will do.

But wait, you ask, doesn't the Fed publish its estimate of the long-run policy rate? How can that be private information? Yes, they do, and it's right here. However, the broader point of Stein and Sunderam's analysis is what matters. The Fed will always have some private information about its own reaction function. If it didn't, and markets knew how the Fed would react to every possible contingency, then there would be no market reaction to FOMC announcements -- and this is manifestly false. The only way the Fed could have a fully-public reaction function, I'd argue, is to commit to a Taylor rule or something of that spirit. It won't.

Stein and Sunderam's advice, of course, has to be weighed against the standard case for forward guidance from Michael Woodford, which contends that, when interest rates fall to zero, recovery today requires aggressive commitments about tomorrow. Some reconciliation of these two positions is necessary.

If the Fed chooses to wait, just about the worst thing it could do, Stein and Sunderam would say, would be to indicate in any way that this choice was informed by recent volatility in financial markets. And if it chooses to go ahead, the Fed will need to find some way to convince markets it's not kidding around when it says "data-dependent" -- a sales job, by the way, on which it totally gave up amid the taper.

Killing the dot plot or the primary dealer survey would send that message. It might talk a little about its reaction function instead.