FOMC Decides to Focus on the Rudder, Not the Destination

The FOMC minutes from the December meeting reveal that starting this month the Fed will start publishing conditional long-term forecasts for the federal funds rate in its Summary of Economic Projections (SEP):

At the conclusion of their discussion, participants decided to incorporate information about their projections of appropriate monetary policy into the SEP beginning in January. Specifically, the SEP will include information about participants’ projections of the appropriate level of the target federal funds rate in the fourth quarter of the current year and the next few calendar years, and over the longer run; the SEP also will report participants’ current projections of the likely timing of the first increase in the target rate given their projections of future economic conditions.

So what to make of this new policy? One view is that it provides more certainty about the future path of the target policy interest rate. Consequently, it would easier to make long-term investment decisions and that added certainty by itself might add some stimulus to the economy. The long-term forecast could also be used as a back-door way to provide more monetary stimulus to the economy. The Fed could do this by lowering its long-term forecast of the target federal funds rate which could be interpreted as indicating greater than expected monetary stimulus in the future. This, in turn, would improve the economic outlook and thereby encourage households and firms to increase their spending today. In short, a lower forecast of the future target federal funds rates could raise current aggregate demand.

The FOMC lowering its expected path of the target federal funds rate, however, might also be interpreted as the Fed revising down its economic forecast and adjusting its target interest rate forecast accordingly to maintain the current stance of monetary policy. In other words, a lower long-term interest rate forecast might simply be viewed as the Fed expecting the natural interest rate to remain depressed longer than previously expected and thus needing to hold down its target federal funds rate target longer than expected. Here, the Fed would not be adding stimulus, but maintaining the status quo as the economic outlook worsened. Given the Fed’s failure over the past three years to add sufficient stimulus to restore robust nominal spending and close the output gap, this less favorable interpretation in the current environment would amount to more passive tightening by the Fed.

That there could be different interpretations of the Fed lowering its long-term forecast for the target federal funds rate speaks to a more fundamental problem with this new policy: the Fed has failed to set an explicit nominal target for monetary policy. Not knowing where the Fed is ultimately heading makes it difficult to interpret changes in the FOMC’s long-term interest rate forecast. It is like a captain of a ship who navigates by focusing on the rudder, but fails to set a destination point. It would be far better for the captain to pick his target destination and then adjusts the rudder accordingly. This is why it is so important for the Fed to set a nominal GDP level target. It would provide a clearer road map of where the Fed wants the nominal economy to go and it would make interpreting changes in the expected path of interest rates easier, if not redundant. It is time for the Fed to focus on the destination.

P.S. Cardiff Garcia notes another problem with this new policy:

One longstanding concern about doing this is that the public might misinterpret the projections as a promise of what the Fed will do rather than something contingent on how the economy performs over time, and the minutes noted that at least one committee member expressed this worry.

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