Public Perceptions of the Forward Guidance

In my recent posts (here and here), I have been writing on the FED's forwards guidance program. To me, the forward guidance program is as interesting as the FED's co-unconventional tool, the quantitative easing, is if not as effective as it is. (Actually, I am interested in writing on the QE's aggregate effect on the recovery, but it is scary stuff to touch on) The FED implements the forward guidance (or open-mouth-operation) program to inform the market on when how long the FED will pursue the low interest rate policy and by doing so, it hopes to induce greater investment and consumption from the firms and consumers through the expected low short-term interest rate.

In their recent paper on the effects of forward guidance on the public's perception, Sack et al. suggested two possible public's interpretations of the change in the FED's forward guidance program. Here, the change in the forward guidance program means an extension on the current low interest rate policy. This is exactly the case we are in right now, where the FED has created market expectation that it would raise the short term interest rate as the unemployment rate reaches 6.5%, but now it faces an apparent slight change in their forward guidance policy. According to the authors, the FED's change in the forward guidance policy can get two possible reactions from the market.

First, the market could see the delay of the increase in short-term interest rate as a bad news. In other words, the private sector could interpret the FED's move as a sign of a weak recovery because it believes that the FED extended the low interest rate policy because the economy isn't recovering as the FED presumably forecasted when it set its former policy or the date of the increase in interest rate. In other words, this change in the forward guidance can lower the private sector's confidence in the recovery.  If this is indeed the case, the extension on the low interest policy can't have a positive effect on the behavior of firms and consumers.

The second way the public may interpret the change in the forward guidance is that it could think the FED extended the low interest rate policy to "maintain a more accommodative policy position for a longer period for a given set of macroeconomic conditions."  Unlike the first case, if the public indeed sees the more period of low interest rate as the FED's more aggressive stand on the recovery, the public expect the economy to recover sooner. In that case the, the effect of the forward guidance program on the investment and consumption will be positive.

Therefore, to have a positive effect it initially hoped to have on the consumption and investment through the forward guidance program, the FED now has to tweak its forward guidance policy in a such manner that the public will see the change in the policy as a more accommodative policy rather than just a weak recovery fix.

I want to finish the post asking Ben Bernanke to summarize the points made in this post. Bernanke explained this two possible perceptions very clearly in his following statement made in 2012:

"Has the forward guidance been effective? It is certainly true that, over time, both investors and private forecasters have pushed out considerably the date at which they expect the federal funds rate to begin to rise; moreover, current policy expectations appear to align well with the FOMC's forward guidance. To be sure, the changes over time in when the private sector expects the federal funds rate to begin firming resulted in part from the same deterioration of the economic outlook that led the FOMC to introduce and then extend its forward guidance. But the private sector's revised outlook for the policy rate also appears to reflect a growing appreciation of how forceful the FOMC intends to be in supporting a sustainable recovery."