The irony of Ben Bernanke's forward guidance

Thursday, 21 Nov 2013 | 10:35 AM ET
Federal Reserve Chairman Ben Bernanke
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Federal Reserve Chairman Ben Bernanke

Ben Bernanke outlined how he thinks current monetary policy operates, in a speech Tuesday to the National Economics Club.

Everyone is obsessed, for the moment, with quantitative easing—and Bernanke did have some surprising things to say about that. But for now, it's worth thinking about how the other aspect of current policy—forward guidance—works.

When Bernanke talks about "forward guidance," he's referring to the Fed's strategy to ease monetary conditions when it cannot lower its target rate for lower overnight interbank lending because that rate is already at zero. What Bernanke and his cohorts at the Fed believe is that conditions can be eased further by indirectly targeting longer term rates through a "communications policy."

More specifically, Bernanke thinks (1) that lowering long-term interest rates will stimulate the economy, (2) that long-term rates on risk-free assets (mainly, U.S. Treasury bonds) reflect expectations about the future path of short-term rates, and (3) by altering the expectations about the future path of short-term rates, the Fed can bring down long term rates.

A lot of Bernanke's speech is a description of the Fed's attempts to shift expectations—and the market's stubborn refusal to expect what the Fed wanted it to expect. It wasn't so much a credibility problem as a problem of more purely communications. That is, the market didn't so much doubt the Fed as misunderstand it.

So the Fed kept modifying guidance to take away misunderstandings about what it would take to warrant a hike in the target rate.

What goes unaddressed, however, is a deeper problem.

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Let's say that the market believes Bernanke's theory about the effectiveness of forward guidance in boosting the speed of the economy. In that case, the market should react to by raising longer-term interest rates sooner than it would otherwise—because it should expect to pass the Fed's economic condition thresholds for higher short-term rates sooner.

Obviously this makes forward guidance at least somewhat self-defeating.

As economist Warren Mosler points out, this has an ironic consequence: forward guidance will only work if the market doubts its effectiveness.

If you think forward guidance sounds like the monetary equivalent of a "Field of Dreams"—if you build it, they will come—then you don't think it will do much to boost the economy, which means we won't hit the thresholds for raising rates soon, which in turn holds down longer-term interest rates—and therefore provides stimulus to the economy.

Yes that is every bit as convoluted as it sounds. Forward guidance only works if the market doubts that it works. It's a placebo in reverse.

(Read more: What if they tapered and no one cared?)

Bernanke and the Fed seem to be trying to avoid this problem by emphasizing that the economic guideposts they've set out are "thresholds" and not "triggers." The idea, it seems, is that even if you think economic conditions would warrant higher rates sooner (perhaps because you think the policy works), you don't necessarily expect higher rates at the same time. In other words, the Fed wants to convince us that rates will stay quite low even if the policy works to improve economic conditions.

If all this seems very complex, that's because it is. Mosler has a suggestion that seems currently not even under consideration. If the point of forward guidance is to bring down long-term rates, why not announce a direct target for long-term rates?

From Mosler Economics:

Seems to me the only tool left is unconditional guidance or purchasing securities on a price basis, rather than a quantity basis. Which does of course work, to the basis point.

That is, if the Fed announced it had a 2 percent bid for unlimited quantities of 10 year notes they would not trade higher than 2 percent while that bid was active. My recollection was that this was done during WWII.

And that we didn't lose.

I don't think we'll see anything like that any time soon.

The primary reason is that the Fed still regards long-term rates as a useful economic indicator.

Remember that long-term rates reflect expectations of future short-term rates. Those expectations are the result of a combination of Fed communications of how it will react to economic conditions and information about economic conditions.

Actually setting the price of long-term Treasury notes would have the effect of destroying this informational feedback.

—By CNBC's John Carney. Follow him on Twitter @Carney


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