When setting monetary policy, the Federal Reserve has several tools at its disposal, including open market operations, the discount rate and reserve requirements. The FOMC, which comprises members of the Board of Governors of the Federal Reserve System and five Reserve Bank presidents, is responsible for open market operations, while the board of governors sets the discount rates and reserve requirements. The two factors that have always been present, even before forward guidance became an explicit ECB monetary policy tool, can both be understood as forward guidance surprises, but with different flavours. It turns out that financial markets have always perceived a short-term and a longer-term forward guidance factor.
We call the first factor, which has its peak effect around the six-month maturity with little effect on long-term interest rates, ‘timing’. This is to differentiate it from the second factor, now commonly called ‘forward guidance’, which has a peak effect at two years and significantly affects long-term interest rates. For the QE factor, by contrast, the longer the maturity, the larger the effect. This is consistent with the QE implementation in the euro area, where the average maturity of the securities bought has been about eight years.
At the close of 2020, it’s hard to think of another year in living memory that has forced such a radical rethinking of our politics and social life. The Covid-19 pandemic will be remembered as a dire time in American life, but its disruption may yet open us up to new ideas and social possibilities, especially when it comes to the power of the government to spend. Given that stable exchange rates play such a major role in international trade, it’s essential to find ways to keep them balanced. Central banks have the power to regulate exchange rates between foreign and domestic currencies. For instance, if the central bank opts to issue more currency to increase the money supply, domestic currencies become cheaper than foreign currencies. However, monetary policies also play a major role in unemployment rates.
Once inflation issues have been addressed, expansionary policies can then be implemented to help reduce unemployment rates. This works because the increase in the money supply helps to stimulate the business sector, which also helps to create more jobs. While there may be no way to fully achieve true full employment, the goal is to reduce the rate of unemployment among those who are ready and willing to work for the existing wages.
The FOMC is essentially saying it will not raise interest rates just because the projected unemployment falls below its estimate of the NAIRU unless there are signs of inflation increasing to unwelcome levels. In practice, this means that the FOMC will allow recoveries to go on unimpeded by monetary policy—even if unemployment rates get very low—as long as inflation remains subdued. This more inclusive definition of the employment mandate is thought to be especially beneficial to minority groups and low- and moderate-income communities. Research shows that these groups get disproportionate gains from very low unemployment rates. Average inflation targeting implies that when inflation undershoots the target for a time, then the FOMC will direct monetary policy to push inflation above the target for some time to compensate. With this new approach, the Fed hopes to anchor the expectations of financial markets and others that it can and will do what’s needed to get and maintain inflation at 2 percent on average over time. To compare the old and new Fed statements of long-term goals, see this guide.
Going forward, the Fed plans to conduct a review of the statement every five years. It is also true that the survey was taken over only a short period following the announcement, and as anyone who has ever taught or been a student knows, it takes time to master new material. Still, the results do suggest that more work needs to be done on policy communications to ensure that households will understand the policy strategy and then incorporate it into their expectations and actions.