The Economist has an article discussing the issue of forward guidance in monetary policy. Here’s an excerpt:

To guide expectations credibly, officials must eventually follow through with the changes they indicate. The quandary is deciding what to do when conditions change, as they have since the Powell pivot, with inflationary pressure stronger than expected, which has rendered rate cuts less suitable. Staying the course might no longer be appropriate; changing it risks harming central bankers’ ability to jawbone investors in the future. . . .

Ben Bernanke, a former Fed chairman, once warned that such considerations can quickly degenerate into a “hall of mirrors”. If policymakers mimic market expectations, which then shift as a result, endless distortions are possible. Suitably enough, Mr Bernanke’s more recent work reviewing the Bank of England’s approach to forecasting offers a way out, suggests Michael Woodford of Columbia University. One crucial recommendation was that the bank ought to start publishing its projected policy rate under a range of different economic scenarios, rather than just its central forecast. Doing so would help investors understand how policymakers would react to different conditions, allowing them to change course in response to new data without losing face.

In my view, making interest rate forecasts conditional on macroeconomic conditions is an improvement over unconditional forward guidance.  Unfortunately, it is difficult to predict how changing macroeconomic conditions might impact future movements in the natural rate of interest.

An alternative would be to offer more specific guidance as to the policy goals of the Fed.  For instance, one could imagine a nominal GDP target that calls for 4% annual growth, with make-up policies to correct any short run deviations from this trend line.  This sort of policy regime is called “NGDP level targeting”, because it targets the level of NGDP, not the growth rate.

Even more precise guidance could be provided by specifying the exact nature of the make-up policy.  For instance, the Fed could indicate that the make-up would occur at a rate of 1%/year, until back on the trend line.  Thus if a mistake pushed NGDP 1% above the target path, the Fed would aim for 3% growth over the next 12 months.  If a mistake pushed NGDP 2% above target, the Fed would aim for 3% NGDP growth over the next two years.  If NGDP fell 1.5% below target, the Fed would aim for 5% NGDP growth over the next 18 months.

One advantage of this sort of policy regime is that it would make it easier to interpret the information in interest rate futures markets.  Today, policymakers don’t know whether an anomalous movement in fed funds futures reflects expectations of what sort of future interest rate would be required to achieve 4% NGDP growth, or a lack of confidence that the Fed is actually trying to achieve 4% NGDP growth.  To make the point more concrete, if the fed funds futures show rates falling to 3.5% over the next year, is that because markets expect a weaker economy, or is it because markets expect an easy money policy that will trigger a stronger economy?

I’ve advocated a “guardrails” approach, where the Fed would take unlimited short positions on 5% NGDP growth futures contracts and unlimited long positions on 3% NGDP growth futures contracts.  But even if this market-guided policy regime is politically infeasible, a clearer statement of the Fed’s desired path for NGDP growth would lead to an environment where existing financial markets could provide a rich source of information to policymakers struggling with the question of where to set their interest rate target. 

I believe that setting a clear NGDP level target would lead to much less volatility in NGDP growth over time.  Indeed, an NGDP level targeting regime with a clearly specified make-up rule would likely have allowed us to avoid a severe recession in 2008-09, and a severe inflation overshoot in 2021-22.