The irony of Ben Bernanke's forward guidance

Former Federal Reserve Chairman Ben Bernanke
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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.