In recent years, one hip thing many economic thinkers hype is central bankers’ forward guidance—attempts to substitute language for action to influence interest rates and, thereby, stimulate economic activity. From their pledges to keep rates “lower for longer” or take “symmetrical views of inflation targets,”[i] we are supposed to believe rates will stay low, inflation expectations will rise and borrowers will borrow. Funny thing is, several recent central bank studies show folks are, overall and on average, not getting the message. Even if they are, the theory underpinning this approach seems flawed. To us, exploring this disconnect illustrates yet more reasons investors shouldn’t focus on the Fed.
The theory underpinning forward guidance holds that central bankers’ increased openness about future policy will guide market participants’ and the general public’s expectations. It essentially rejects former Fed maestro Alan Greenspan’s legendary quote, “Since I’ve become a central banker, I’ve learned to mumble with great incoherence. If I seem unduly clear to you, you must have misunderstood what I said.”[ii] When central banks aim to spur borrowing via lowering rates, forward guidance theoretically augments the actual purchase of bonds like Treasurys. If successful, proponents suggest the Fed being clear about its intentions will better boost inflation. Some even argue the Fed could get better results simply by moving its inflation target higher, theoretically nudging the masses’ inflation expectations higher as they foresee the Fed keeping rates lower for longer.
But increasingly, it seems the general public still doesn’t get what Fed heads mean, despite the verbal policy push. A study from early this year by Olivier Coibion, Yuriy Gorodnichenko and Michael Weber highlighted this point. Since 2012, the Fed has targeted a 2% y/y inflation rate, as measured by the headline Personal Consumption Expenditures Price Index. To gauge how much the general public got bankers’ message, these three researchers surveyed ordinary people, asking them to identify the inflation rate the Fed targeted. They found, “Less than twenty percent of respondents correctly answered 2%. Barely 50% answered a number ranging from 0% to 5%. Strikingly, almost forty percent answered that the Federal Reserve was targeting an inflation rate of 10% or more, which suggests a pervasive lack of knowledge on the part of households about the objectives of the Federal Reserve.”[iii] [Boldface ours.] If the general public is this far off on the Fed’s targeted rate, does it really matter if the Fed raises or lowers it? Does it matter if 2% is a ceiling, long-term average or the center of a range?
One key problem bankers face in communicating is likely that central bank-speak is generally quite boring—and often impenetrable.[iv] A recent study by the Bank of Israel echoed this point by scoring various central banks’ written communications—including the Fed’s and ECB’s—on their understandability to the general public. To analyze this, researchers used Flesch-Kincaid readability scores, which assess the difficulty of written text based on US school grade level. Their conclusion: “The announcements by the Fed require an average of about 17 years of schooling, and those of the ECB require about 19 years of schooling.”[v] So, essentially, some graduate school. That … doesn’t seem like clear communication to the public? Perhaps they ought to consider the Bank of Jamaica’s method and teach the importance of inflation targeting through music videos. Even this may not work, though. ECB researchers recently found that the public is generally unaware of central bank announcements, however bankers issue them.
We know, shocker. Average folks, in our view, likely have better things to do than size up the latest central bank babble. Hence, it didn’t shock us back in 2014, when a Pew Research survey found that only 24% of Americans surveyed correctly picked Janet Yellen from a list of four people as the Fed chair at the time. Nearly 48% said they didn’t know. Another 17% picked Alan Greenspan (who left the post in 2006, with Ben Bernanke serving in between). The other 11% picked one of two Supreme Court Justices.[vi]
But also, even if the Fed successfully influences public behavior through its forward guidance, convincing the public that low rates would last for a long time doesn’t seem likely to stimulate real much. It seems to us they would get more bang out of creating urgency—sort of like those Cyber Monday or Black Friday emails warning you that huge bargains are expiring now! Even though another email will likely pollute your inbox overnight declaring another limited-time extension, probably at a deeper discount. Telling folks low rates will be around for the long haul doesn’t seem likely to encourage someone to get a loan and deploy the cash now. No reason to rush! The belief lower for longer equals stimulus is another example of the Fed presuming the level of rates determines policy. This is, as Milton Friedman’s work on the Great Depression showed, wrong.
Many think forward guidance targets markets, setting expectations for big investors. Perhaps that is correct, but markets pre-price widely known factors. Hence, issuing forward guidance doesn’t actually mean rates stay low for the longer run. They would be reflected near-immediately, then move on to assess developments over the foreseeable future. Which is precisely what they would do with actual Fed actions, too.
This all speaks to two longstanding tenets of ours: Like politicians, watch what central bankers do, not what they say. Additionally, people ascribe far too much clout and aptitude to Fed officials. Much more than history suggests they deserve! So don’t hang on every word of the Fed chair, governors or regional presidents. It isn’t worth your time, in our view.
[i] This is a really fancy way of saying that if the central bank undershoots its target for a spell, it will equivalently overshoot its target in the future. They could probably just say it’s a long-run average, but we guess they are aiming for hifalutin-sounding terms.
[ii] “Monetary Policy Communications and Their Effects on Household Inflation Expectations,” Olivier Coibion, Yuriy Gorodnichenko and Michael Weber, January 2019. https://eml.berkeley.edu/~ygorodni/CGW_expectations.pdf
[iv] See note i.
[v] “Measuring Communication Quality in the Bank of Israel's Interest Rate Announcements,” Jonathan Benchimol and Itamar Caspi, The Bank of Israel, October 24, 2019. https://www.boi.org.il/en/NewsAndPublications/PressReleases/Documents/Measuring%20Communication%20Quality%20in%20the%20Interest%20Rate%20Announcements.pdf
[vi] “Who’s in Charge of the Fed? Don’t Bank on the Public Knowing the Answer,” Seth Motel, Pew Research, October 6, 2014. https://www.pewresearch.org/fact-tank/2014/10/06/whos-in-charge-of-the-fed-dont-bank-on-public-knowing-the-answer/
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