Thought on Forward Guidance: Proposal for the Fed

The FED has been pursuing its so called "forward guidance" program hoping it could stimulate economy by convincing the persistence of low interest rate policy. It stated that it sees the current low interest rate appropriate as long as the unemployment rate remains above 6.5% and the expected inflation in one to two years is below 2.5%. According to the statement, it will consider the broader labor indicators and inflation expectations to decide how long it will continue the near zero interest rate policy once the unemployment rate drops to 6.5%. Therefore, it is very up in the air when the FED is increasing the federal funds rate.

We know that the latest report shows the unemployment rate is 6.6%.  This rate indicates that even though the monthly net number of jobs added hasn't been up to the projections for last two months, the FED will soon be deciding its future policy and writing up its well-into-future forward guidance once the unemployment rate hits 6.5%.

After all, the FED's low interest rate policy has been directed toward increasing investment. But there could be different type of "forward guidance" that could potentially create more investment as the FED wishes. My proposal to the FED is that:

a) It should forward guide the market by putting hard deadline on when it is increasing the federal funds rate and therefore the market interest rates. How this clear deadline for increase in federal funds rate works is following: If the FED successfully (!) convince the market that it will indeed push up the federal funds rate, the investors will have clear expectation of when the overall market interest rates are rising. Therefore, realizing the higher investment cost in the specific future, firms will have incentive to borrow and invest today before the FED raises the interest rate. Hence, the investment could increase as the FED has been wishing. This argument is analogical to the people's consumption when there is very high inflation expectation. If the expected inflation is very high, people would try to buy goods as soon as possible. But the one difference between these two analogies is we don't know what interest rate is very high to be analogy to the high inflation rate.

One might say that then if there is higher demand for loanable funds because of this policy, the interest rate will rise in the loanable funds market. But we have to remember, the FED has control over overall interest rate in the economy (or I believe so), it will pursue its current near zero interest rate policy until the date it forward guided comes.

b) Again, to succeed in increasing investment, the FED must be able convince the market that it is indeed increasing the federal funds rate at that certain date, To convince the market, the FED should set the date to be in near future and interest rate minimally higher in first few periods and commit to what it said.

According to latest report, the expectation of the FED's federal funds rate in June 2015 has lowered in a recent month. This might be showing that the FED's forward guidance indeed successfully convinced the market that the FED will be pursuing near zero interest rate policy. If current forward guidance is indeed somewhat successful, I believe the proposed forward guidance could be also successful.

Remember, at the time when the FED sets the specific date to increase the interest rate, the interest rate will be still zero percent, therefore there will be no negative shock to the total investment.

The problem to implement this forward guidance is that the FED cannot surely know how bad or good the economy will be performing at the time of its forward guided date. The FED could announce its first date to increase the interest rate once the unemployment rate reaches 6.5%. If the FED chooses 3 months to increase the federal funds rate after the unemployment reaches 6.5%, it can study how the investment behaved during this 3 months when the market believes the increase in the interest rate is coming. If the sign turns out to be good, the FED can further implement this "hard deadline for minimal increase in federal funds rate" forward guidance.

Does the recent low interest rate induce more investment?

 As Keynes argued that the solution to the Great Depression was to create more investment through a reduction in interest rates, one of the goals the Fed pursued through its near zero interest rate policy was to lower overall interest rate in the economy and create more investment. As we studied from IS-LM model, I(nvestment) part of the model is a decreasing function of the real interest rate. But, of course, IS-LM model is very simplified but useful to see effects of certain changes in the economy isolated from other factors. If we naively assume the model's argument and recent economic condition since the recession, we would expect total investments to be risen since the Fed has shifted to zero interest rate policy. As the monetary policy makers lowered the interest rate to near zero, the economy has been seeing the only period of below zero real interest rate which wasn't created by high inflation as it was in the 1970's.

Historical real interest rate ( 10-year rate minus personal consumption expenditure inflation rate)

We would expect businesses to borrow money with negative real interest rate and invest it to their businesses, right? Recent research done by by Federal Reserve staff economists Steve Sharpe and Gustavo Suarez showed that businesses investors were inelastic to low interest rates. According to the paper,

The vast majority of CFOs indicate that their investment plans are quite insensitive to potential decreases in their borrowing costs. Only 8% of firms would increase investment if borrowing costs declined 100 basis points, and an additional 8% would respond to a decrease of 100 to 200 basis points.

Strikingly, 68% did not expect any decline in interest rates would induce more investment.

In addition, we find that firms expect to be somewhat more sensitive to an increase in interest rates. Still, only 16% of firms would reduce investment in response to a 100 basis point increase, and another 15% would respond to an increase of 100 to 200 basis points.

Read more: http://www.businessinsider.com/business-investment-sensitivity-to-interest-rates-2014-1#ixzz2qXqvjHoN

In other words, one of the goals, namely to increase investment, that the policy makers hoped to achieve through the low interest rate policy hasn't been achieved.

Private non-residential fixed investment, federal funds rate, and real interest rate

If we look at the above graph, business sector hasn't been really responding to the historically low real interest rate. It may be due to the uncertainty created by the Fed's policy tools.

Overall, total real private investment hasn't gotten back to a level it was at before the recession.

This slow increase in private investment has been one of the reasons the recovery has been slow since the recession. The Fed should increase the business and consumers confidence to increase investment.