Michael Woodford Warns "By Blinking [On Taper], [The Fed] Has Made A Negative Reaction More Likely"
Widely credited with being the seminal paper at the 2012 Jackson Hole conference and setting the scene for "threshold-based" policy, Michael Woodford discusses his views on the costs and benefits of "forward guidance" in this Goldman Sachs interview. The Columbia professor explains how he thinks about asset purchases versus forward guidance (it’s a mistake to think of asset purchases as a way to avoid having to talk about future policy intentions), and why the market and the Fed have seemed so disconnected at various points this year despite substantial attempts by the Fed to communicate more clearly (there were mistakes in communication, but that does not mean the situation would have been better if the Fed had instead kept its mouth shut, especially in such unprecedented times.) Ultimatley he warns, "by blinking when they did, I fear that they have made a negative reaction more likely in the future, because they are now back to square one, with people once again lacking a clear sense of how close the Fed is to tapering and thus vulnerable to surprise."
Goldman Sachs' Allison Nathan Interview with Michael Woodford,
Allison Nathan: Haven’t central banks always tried to influence interest rate expectations? What is so special about forward guidance today?
Michael Woodford: No, central banks have not tried to do things that were at all similar to this in the past. Until quite recently, all central banks were very reluctant to say things in advance about future policy decisions, and this reluctance remains to varying degrees at many banks. The forward guidance adopted by the Fed and other central banks, which tries to influence expectations by actually saying things about policy intentions, is therefore a new policy tool and indeed one that has become more important given the near-exhaustion of the most traditional policy tool – adjusting policy rates – as rates across the major economies already hover around their effective lower bound.
Allison Nathan: What are the benefits of forward guidance?
Michael Woodford: If policy expectations matter – and I think it is pretty clear that they are crucial to how longer-term assets end up getting priced – then there are two kinds of advantages of explicitly discussing future policy by the central bank. One advantage is that it can reduce misunderstandings about policy intentions, which, in turn, can reduce uncertainty for the central bank about the effect of its policy on the markets. In principle, talking directly about policy intentions would allow the use of more complex policies, which might not otherwise be pursued for fear that they would not be understood without explanation. The second general type of gain from explicitly talking about future policy is to help ensure that the policy committee itself will follow through with its commitments even though it may have motives to depart from them later on.
Both of these potential advantages are particularly clear when you reach an effective lower bound on policy rates. At that point, convincing people that the policy rate will remain “lower for longer” can help ease financial conditions today, providing additional stimulus to the economy when traditional tools no longer can. But talking about the intention of “lower for longer” is crucial because being at this lower bound is a very unusual situation, so there is little past experience that people can look to in order to anticipate how the central bank is going to respond. There is also a clear need for the central bank to commit itself in advance in order to achieve the stimulative benefit. That is because of course later – when the stimulus has worked and the economy is improving - the bank will have little motivation to actually keep rates low (the so-called “time inconsistency” problem) unless they committed to do so in advance. To overcome that problem, the central bank needs to make an explicit promise that would be difficult or embarrassing to just completely ignore later.Here's Allison.
Allison Nathan: What are the dangers of forward guidance?
Michael Woodford: The most obvious danger, which has likely been the main reason for central banks’ reluctance to talk about future policy in the past, is the possibility that a policy commitment that looks sensible at some earlier time turns out to be unwise because things happen in the meantime that the central bank did not expect. Those costs can be reduced without losing all of the potential benefits of forward guidance if the central banks think carefully about what kind of commitments about future policy should be made. It makes sense to avoid unnecessary specificity about things that do not need to be specified too precisely in order to achieve the desired change in expectations. For example, in the case of a commitment to keep the federal funds rate low for longer in order to stimulate the economy today, the central bank could make a very specific commitment about the path of the policy rate over time. But there would be much more likelihood of embarrassment in that case than if the bank instead committed to keep rates low until certain economic conditions arise, whenever that may be....MUCH MORE
Previously on the Woodford channel:
Marginal Revolution's Tyler Cowen: "...Kaminska Wins"
Let's Just Proclaim Jubilee: "Quantitative easing should be used to write off government debt"
Evans-Pritchard: 'BIS and IMF attacks on quantitative easing deeply misguided warn monetarists'
Helicopter money as a policy option
Also Alphaville's Woodford and the QE tradeoffs, revisited.
