"I consider these thresholds for possible action a major improvement in forward guidance," enthused Fed Chair-Designate Janet Yellen last April. "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."
Actually, they don't.
Forward Guidance may be all the rage among the world's central banks, but it's not going according to script. Markets laughed off the Bank of England's Everyday Low Rates pledge in August, pushing the pound up and gilts down – the reverse of what was intended – after concluding that it said nothing, and lacked conviction to boot. Since then, the UK unemployment rate has declined much more quickly than the Bank expected, prompting it to bring forward its forecast of when it will reach the Bank's 7 percent threshold for possible rate hikes from mid-2016 to late 2014. A recent survey by Reuters showed that 13 (32%) of the 41 economists polled now expect that the Bank will lower its threshold, three times the percentage who thought so last month.
As for the Fed, its foray into forward guidance started out with more promise. In August 2011, the Fed announced that rates were likely to remain exceptionally low "at least through mid-2013." Prior to the announcement, primary dealers had expected the Fed to raise rates in the fourth quarter of 2012; following it, they expected the first increase to be delayed a full year – until the fourth quarter of 2013. In October 2012, the Fed issued revised guidance: it would now keep rates near zero through mid-2015. The market immediately reacted as the Fed wanted, re-centering expectations on a rate hike in mid-2015.
At its next meeting, however, the Fed abandoned date-based guidance in favor of data-based guidance: a pledge to keep rates near zero until the unemployment rate fell below 6.5%. It emphasized, though, that the two pledges were consistent, as it didn't expect unemployment to fall below that level until mid-2015. The Fed justified the shift from date-based to data-based guidance by stating that the latter "could help the public more readily understand how the likely timing of an eventual increase in the federal funds rate would shift in response to unanticipated changes in economic conditions and the outlook." But has it?
Fast forward, and the unemployment rate has been falling much faster than the Fed anticipated back then; the Fed now expects it to dip below 6.5% later this year. Yet as the attached figure shows, the market has revised its rate expectations in the opposite direction; it now believes a hike will not come until late 2015.
For its part, the Fed has said nothing to nudge the market toward its amended (data-based) guidance; in fact, it is now suggesting that rates are likely to stay low "well past the time" the unemployment rate reaches 6.5%.
Outgoing Fed Chair Ben Bernanke had in June of last year also indicated that QE3 monthly asset purchases could be expected to end when unemployment hit 7%, whereas a tapering of asset purchases is only now just starting with unemployment at 6.7%.
All this suggests that the Fed's experiment with data-based guidance is a flop. The 6.5% guidance may have been announced to help the public understand how the Fed would respond to "unanticipated changes in economic conditions," but the Fed appears to have buried it because the unanticipated changes in the unemployment rate came about for unanticipated reasons – in particular, a big drop in the labor force participation rate.
Before the Fed moves on to the next generation of guidance markers, it ought to think twice about the risks of worsening, rather than improving, the signal-to-noise ratio in its communications. The jolt to the bond markets from the chairman's unanticipated taper talk last May suggests what's at stake as the Fed reverses the trajectory of policy from accommodation to tightening.
-- Benn Steil is director of international economics at the Council on Foreign Relations and author of The Battle of Bretton Woods. Dinah Walker is an analyst at the Council.
This article appears in full on CFR.org by permission of its original publisher. It was originally available here.