The Fed is now engaged in the game of “forward guidance”—they’ve announced that they anticipate keeping interest rates at zero, until late 2014—and hope that it will shape the recovery. But what effects will this announcement have? To figure this out, let’s visit two of the greatest ever Fed Chairmen: Eeyore and Tigger.
It could be that Fed Chairman Ben Bernanke is like Eeyore:
Eeyore is a true dismal scientist, who sees bad news everywhere. He’s sure the economy will be in the doldrums for years. Indeed, he’s so worried that folks who don’t understand his pessimistic outlook will make bad decisions that he gives a speech warning them about it. He says the economy is so weak that he’ll need to keep rates low for several years.
Eeyore’s message is so sobering that it mutes the desired stimulus effect of the low interest rates. After all, why would you buy anything, or invest in producing it, if you have just learned that some of the smartest forecasters in the country think the economic outlook is so awful that they dare not raise rates until 2014?
Or alternatively, perhaps he’s more like Tigger:
Chairman Tigger has a totally different approach. He figures that the prospect of a terrific party will revive everyone’s animal spirits. He also knows what folks are thinking: Every time the economy gets going, the Fed spoils the party by taking away the punch bowl — that is, by raising interest rates to keep inflation in check. So Tigger gives a speech promising to keep interest rates low for several years — even when the economy recovers.
The prospect of low interest rates sustaining a long and robust recovery leads everyone to start spending. After all, good times are just around the corner.
Notice the problem here? Eeyore and Tigger both did very similar things—they each announced that interest rates would be low for several years—but each had a different effect. What’s up?
Eeyore is providing what economists call “outlook guidance” — he’s sharing what his economic-forecasting team thinks about the future. By contrast, Tigger is providing “policy guidance” — telling us what the central bank is going to do, and promising it will do it, no matter what.
So is Bernanke taking a page from Eeyore’s playbook, or from Tigger’s? The most recent Fed statement says that it “currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014.” Sounds like Eeyore, right? After all, he says that interest rates will be low only because the Fed is forecasting “low rates of resource utilization.” Bernanke “anticipates” low interest rates, but he’s quite clearly not promising them. San Francisco Fed President John Williams has been even clearer that the Fed is pursuing Eeyore’s strategy, saying that “our statements are not an absolute commitment to keep rates near zero. It’s simply the FOMC’s current judgment about the best future course of policy. If the economic outlook changes, then the guidance could change too.”
The problem with Eeyore, is that he doesn’t much stimulate the economy:
Economists studied this issue in the early 2000s, and concluded that when you can’t push interest rates any lower, Tigger’s strategy is best. Markets want to know that the Fed is committed to helping the recovery and won’t risk it to fight the specter of inflation…
Small as it may sound, the distinction is important. Businesses are always suspicious that Bernanke may try to sound like Tigger, but revert to being Eeyore when the recovery starts. To succeed at the game of forward guidance, Bernanke needs to convince us he’s committed to low rates in the short-term even if the economy improves. It’s about fully embracing a loveable tiger, or risk being mistaken for a miserable donkey.
I never thought I would ever have the opportunity to offer advice like this:
It’s time, Chairman Bernanke, to bounce on your tail.
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