The Economist has an article discussing the issue of forward-looking monetary policy. Here is the episode:
To guide expectations credibly, officials must ultimately follow through on the changes they demonstrate. The dilemma is deciding what to do if conditions change, as they have since Powell’s pivot, with stronger-than-expected inflationary pressures, making rate cuts less appropriate. Staying on course may no longer be appropriate; changing it risks harming the central bank’s ability to bond investors in the future. . . .
Ben Bernanke, former chairman of the Fed, once warned that such considerations could quickly turn into a “hall of mirrors”. If policymakers mimic market expectations, which then change as a result, permanent distortions can occur. Accordingly, Mr Bernanke’s recent work to review the Bank of England’s forecasting method offers a way out, suggests Michael Woodford of Columbia University. Another key recommendation was that the bank should start publishing its proposed policy rate under a range of different economic conditions, rather than just its average forecast. Doing so will help investors understand how policymakers will react to different situations, allowing them to change course in response to new data without losing face.
In my view, making interest rate forecasts conditional on macroeconomic conditions is an improvement over unconditional oversteer. Unfortunately, it is difficult to predict how changes in macroeconomic conditions may affect future movements in the natural rate of interest.
Another would be to provide specific guidance about the Fed’s policy objectives. For example, one can think of a GDP target that requires annual growth of 4%, with corrective policies to correct any short-term deviations from this trend line. This type of policy is called “NGDP level targeting”, because it targets the level of NGDP, not the growth rate.
More precise guidance can be provided by specification specific type of makeup policy. For example, the Fed may indicate that the formation will occur at a rate of 1%/year, until a return to the trend line. So if the error pushes NGDP 1% above the target path, the Fed will aim for 3% growth over the next 12 months. If the error pushed NGDP 2% above target, the Fed would aim for NGDP growth of 3% over the next two years. If NGDP falls 1.5% below target, the Fed will target NGDP growth of 5% over the next 18 months.
Another advantage of this type of policy process is that it will make it easier to interpret information about future interest rate markets. Today, policymakers don’t know whether the dramatic move in fed funds futures reflects expectations of what kind of interest rate will be needed to achieve 4% NGDP growth, or a lack of confidence that the Fed is actually trying to achieve 4% NGDP. growth. To make the point even more obvious, if fed funds futures show rates falling to 3.5% next year, is it because the markets are expecting a weak economy, or is it because the markets are expecting easy monetary policy that will make for a strong economy?
I advocated a “precautionary” approach, where the Fed would take unlimited short positions in 5% NGDP growth futures contracts and unlimited long positions in 3% NGDP growth futures contracts. But even if this market-directed policy regime is politically impossible, a clear statement of the Fed’s desired path for NGDP growth will lead to a place where existing financial markets can provide a rich source of information for policymakers grappling with the question of where to put it. their interest rate policy.
I believe that setting a clear target for the level of NGDP will lead to less volatility in NGDP growth over time. Indeed, an NGDP targeting regime with a clearly defined structural policy would have allowed us to avoid a major recession in 2008-09, and a sharp rise in inflation in 2021-22.
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