Zero till the cows come home...

If I had to single out *the* one issue I have with Ben, it’s his communication policy. For someone who has researched and written himself about the efficacy of communication as an instrument of monetary policy, his execution has been at best confounding.

Take his commitment to keep the Fed Funds rate low “for an extended period”. The idea here is that, by guiding markets to expect near-zero short-term rates for long enough, long-term rates would also fall, since they are, by and large, composites of expected future short-term rates.

But till when is “long enough”? Till the output gap closes? Till unemployment falls to a certain level? Till inflation is restored to a preset target? Till a Taylor rule dictates a rise in interest rates? Till mortgage or corporate debt yields decline to desired levels? Till the cows come home??! Longer than that??!

It’s not clear! And this dilutes the Fed’s ability to achieve its objectives for two reasons: First, in the absence of a clear Fed target, each market participant will have a different view as to how many periods ahead the short-term rate will stay at near-zero. I mean, it’s unrealistic to expect that all these goals will be magically fulfilled at exactly the same moment in the future. Any impact on long-term rates will be blurred, therefore.

Importantly, different views about the Fed’s priorities could exacerbate differences in the market’s views about the due shape of the yield curve: For example, I may think that the Fed is focused on reducing unemployment, and is prepared to tolerate more inflation. You, on the other hand, might think that the Fed is targeting a specific long-term interest rate with the view of kickstarting credit markets.

Not only will “extended period” mean different things for you and me; we will also have different expectations about the macroeconomic environment and the risks that would emerge as a result of the Fed trying to deliver on its priorities. In other words, we will likely have different views about the due slope and curvature of the yield curve, which doesn’t really bode well for the Fed’s attempts to manage our expectations on that front.

Similar problems surround the Fed’s purchases of long-term Treasuries. After a few back and forths, Ben finally threw the bombshell on March 18th and announced the purchase of “up to $300 billion” worth of Treasuries over six months. But where did the $300 billion come from? In the absence of a clear stated target, it looks like it came out of thin air.

“That’s unfair!”, Ben protests. “Look at the FOMC statement, the objective is there, ‘to help improve conditions in credit markets’”. Well, maybe, by clearly the markets disagreed.

If in doubt, see what happened last Wednesday. Ten-year Treasury yields jumped above 3% (the “ceiling” markets thought Ben might have had in mind) after the FOMC stopped short of announcing the expansion of the Treasury purchase program. Basically, in the market’s opinion, maintaining the 10-year rate at 3% or lower takes more than $300 billion!

So maybe Ben should announce an explicit ceiling for the long-term yield? If credible enough, it could even turn out that he might not have to spend a single dime on Treasuries, as the markets would adjust to that target on their own.

As a matter of fact, in his famous "It" speech on deflation, Ben pointed precisely to this option:

“A more direct method [to bring long-term rates down], which I personally prefer, would be for the Fed to begin announcing explicit ceilings for yields on longer-maturity Treasury debt (say, bonds maturing within the next two years). The Fed could enforce these interest-rate ceilings by committing to make unlimited purchases of securities up to two years from maturity at prices consistent with the targeted yields.” (my emphasis)

So how about that for clarity?

I think it’s the wrong kind of clarity. In fact, “it” speech regardless, I personally doubt that Ben will go down that route and would protest if he did.

First, because it’s unclear whether the measure will “succeed.” I am putting “succeed” in quotes, because success here needs to be defined. I have no doubt that the Fed can keep up a promise to maintain the 10-year rate at, say, 3% max. After all, it can go and buy the entire stock of 10-year notes and bonds, if that’s what it takes. So, if success is defined as the narrow objective of bringing down a particular (set of) Treasury interest-rate(s), the Fed certainly has the ability to deliver.

But this is too narrow a definition of success. The whole point after all is to bring down the private cost of borrowing and get demand for credit going. And while, in principle, a decline in the long-term Treasury rates should transmit itself, at least partially, to private long-term interest rates, in practice it might not.

For example, credit supply constraints, say due to a dysfunctional banking sector, may be demanding a steep upward-sloping yield curve to preserve bank profitability. Or it may be that markets see a huge disconnect between the Fed’s target long-term rate and their own economic forecasts. It may even be the case that the Fed’s own policy of massive Treasury purchases raise doubts about its ability to deliver on its price-stability mandate in the future, pushing private long-term borrowing rates up.

So no, the clarity I’m talking about is not one about the Fed’s instrument, but clarity about its endgame. You see, commitments of the “extended period” type, or the “$300 billion” one, can’t effectively guide expectations, unless they are conditioned upon an ultimate metric of success.

In Japan, for example, the Bank of Japan (BoJ)’s commitment to keep interest rates at zero became far more effective in guiding expectations once the BoJ clarified exactly what it meant by the threat of deflation being dispelled (more that TWO years after it embarked on quantitative easing, by the way!).

A harder question is whether binding the Fed’s hands with an explicit objective, or ranking of objectives, makes sense, especially given how complex and multifaceted the problems it’s trying to address are. I’d say it is, since the absence of clarity can undermine the efficacy of the Fed’s unconventional policy toolkit. I should perhaps add that I also think the Fed currently has too much on its plate and it could do with more/better help from the fiscal authorities, the regulators and Congress.

Ultimately, the market needs clear and verifiable metrics, particularly at the zero bound, when the assessment of the monetary stance becomes a complicated affair. So Ben, pick anything you want—a target for inflation, the price level, unemployment, GDP growth, private credit growth, restoration of bank health, or a combination—and give us the clarity we need... Just not the cows, please.. unless you want the entire bond market to move to Wisconsin in search of guidance!