Fed Vice Chair Gives Magnificent Speech On The 'Revolution' In Monetary Policy That Almost Nobody Talks About

Janet Yellen

Since the onset of the financial crisis, the Fed has famously engaged in “unconventional” measures to ease monetary policy.

Unconventionality has been required, since short term interest rates have dropped to ~0%, and the Fed can’t lower rates below that. So it has to try new tools.

One tool that’s well known is Quantitative Easing, where the Fed tries to lower long-term rates and inject liquidity via the purchase of long-dated bonds.

Quantitative Easing (AKA: “QE”) gets discussed and analysed to death. It’s very controversial (especially among those who don’t understand it), and there’s an obsession about what happens when QE runs out.

But there’s another unconventional tool that hardly gets discussed at all, and yet it’s arguably way more powerful.

That tool is the power of enhanced communication, where the Fed gives strong guidance about future monetary policy (e.g. how long rates will remain low and what thresholds the Fed is looking to see hit before it considers tightening).

It’s this second tool — communication — that is the subject of a new speech from Fed Vice Chair Janet Yellen.

She notes that this communication represents a “revolution” in monetary policy.

Recently I used the word “revolution” to describe the change from “never explain” to the current embrace of transparency in the FOMC’s communication. That might sound surprising to an audience that knows very well what it feels like to be in the middle of a communications revolution. The speed and frequency of most communication, it seems, never stops growing, and I will admit that the FOMC’s changes to the pace and form of its communication seem rather modest in comparison. I’ve mentioned the Chairman’s quarterly postmeeting press conferences, which were initiated two years ago. While these events are televised and streamed live, the mode for most of the FOMC’s communication is decidedly old-school–the printed word.

The Committee’s most watched piece of communication is the written statement issued after each of its meetings, which are held roughly every six weeks. It may seem quaint that my colleagues and I continue to spend many hours laboring over the few hundred words in this statement, which are then extensively analysed only minutes after their release.  The revolution in the FOMC’s communication, however, isn’t about technology or speed. It’s a revolution in our understanding of how communication can influence the effectiveness of monetary policy.

So why is communication powerful?

Because by telling the private sector how long the Fed will keep conditions as they are, the private sector can react accordingly, and know that if conditions are weak, they don’t have to worry about premature tightening.

This is a long section of Yellen’s speech, but in it she explains how communication augments quantitative easing.

It is important to emphasise that the effects of asset purchases also depend on expectations. If the FOMC buys, say, $10 billion in longer-term securities today but is expected to sell them tomorrow or very shortly, there will be little effect on the economy. Current research suggests that the effects of asset purchases today depend on expectations of the total value of securities the FOMC intends to buy and on expectations of how long the FOMC intends to hold those securities. To make these asset purchases as effective as possible in adding accommodation, the FOMC, therefore, needs to communicate the intended path of Federal Reserve securities holdings years into the future. I will return in a moment to current and possible future ways in which the FOMC does and might communicate this information.  The other unconventional policy designed to contribute to monetary easing was almost purely communication–enhanced forward guidance about how long the Committee expects to maintain the federal funds rate near zero.

The situation in early 2009 was similar to 2003 but even more challenging, because in that earlier episode, the FOMC at least retained the option of a further reduction in the federal funds rate target. In 2009, communication about the future path of the federal funds rate was the only option.  Initially, the forward guidance was simple and familiar: The FOMC statement noted that “economic conditions are likely to warrant exceptionally low levels of the federal funds rate for an extended period.” The Committee enhanced its forward guidance in August 2011, when it substituted “at least through mid-2013” for the words “an extended period.” This date was moved into the future several times, most recently last September, when it was shifted to mid-2015.

This “calendar guidance” was an advance over the indefinite “extended period,” but it suffered from an important limitation. The date failed to provide the public with a clear understanding of what conditions the FOMC was trying to achieve or the economic conditions that would warrant a continuation of the policy. As a consequence, it was hard for the public to tell whether a change in the calendar date reflected a shift in policy or a change in the Committee’s economic forecast. 

To help provide greater clarity about the Committee’s objectives, in January 2012, the FOMC adopted and released a statement of its longer-run goals and monetary policy strategy. This statement laid out, for the first time, the rates of inflation and unemployment that the FOMC considers consistent with the dual mandate. Specifically, it stated that the longer-run inflation goal most consistent with the FOMC’s price stability mandate is 2 per cent, and that the central tendency of FOMC participants’ estimates of the longer-run normal rate of unemployment ranged from 5.2 to 6 per cent. 

As the statement also made clear, economic developments may cause inflation and unemployment to temporarily move away from the objectives, and the Committee will use a balanced approach to return both, over time, to the longer-run goals.

On the one hand, for example, the current rate of unemployment, at 7.7 per cent, is far above the 5.2 to 6 per cent range in the statement and is expected to decline only gradually. Inflation, on the other hand, has been running at or below 2 per cent and is expected to remain at similar levels for several years.

In this circumstance, both legs of the dual mandate call for a highly accommodative monetary policy. With unemployment so far from its longer-run normal level, I believe progress on reducing unemployment should take centre stage for the FOMC, even if maintaining that progress might result in inflation slightly and temporarily exceeding 2 per cent. The Committee reaffirmed this statement in January 2013, and I expect it to remain a valuable roadmap for many years to come, indicating how monetary policy will respond to changes in economic conditions.11  

Meanwhile, the FOMC has continued to enhance its communication about how it would use the federal funds rate to return inflation and unemployment to its longer-run objectives. Last December, the Committee replaced its calendar guidance for the federal funds rate with quantitative measures of economic conditions that would warrant continuing that rate at its current very low level.

Specifically, the Committee said it anticipates that exceptionally low levels for the federal funds rate will be appropriate “at least as long as the unemployment rate remains above 6-1/2 per cent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 per cent longer-run goal, and longer-term inflation expectations continue to be well anchored.”

I consider these thresholds for possible action a major improvement in forward guidance. They provide much more information than before about the conditions that are likely to prevail when the FOMC decides to raise the federal funds rate. As for the date at which tightening of monetary policy is likely to occur, market participants, armed with this new information about the Committee’s “reaction function,” can form their own judgment and alter their expectations on timing as new information accrues over time. 

These thresholds will, as a consequence, allow private-sector expectations of the federal funds rate to fulfil an important “automatic stabilizer” function for the economy. If the recovery is stronger than expected, the public should anticipate that one or both of the threshold values will be crossed sooner and, hence, that the federal funds rate could be raised earlier. Conversely, if the outlook for the economy unexpectedly worsens, the public should expect a later “liftoff” in rates–an expectation that would reduce longer-term interest rates and thereby provide more-accommodative financial conditions.

Read the full speech here —>

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