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November 20, 2013
The Shadow Knows (the Fed Funds Rate)
The fed funds rate has been at the zero lower bound (ZLB) since the end of 2008. To provide a further boost to the economy, the Federal Open Market Committee (FOMC) has embarked on unconventional forms of monetary policy (a mix of forward guidance and large-scale asset purchases). This situation has created a bit of an issue for economic forecasters, who use models that attempt to summarize historical patterns and relationships.
The fed funds rate, which usually varies with economic conditions, has now been stuck at near zero for 20 quarters, damping its historical correlation with economic variables like real gross domestic product (GDP), the unemployment rate, and inflation. As a result, forecasts that stem from these models may not be useful or meaningful even after policy has normalized.
A related issue for forecasters of the ZLB period is how to characterize unconventional monetary policy in a meaningful way inside their models. Attempts to summarize current policy have led some forecasters to create a "virtual" fed funds rate, as originally proposed by Chung et al. and incorporated by us in this macroblog post. This approach uses a conversion factor to translate changes in the Fed's balance sheet into fed funds rate equivalents. However, it admits no role for forward guidance, which is one of the primary tools the FOMC is currently using.
So what's a forecaster to do? Thankfully, Jim Hamilton over at Econbrowser has pointed to a potential patch. However, this solution carries with it a nefarious-sounding moniker—the shadow rate—which calls to mind a treacherous journey deep within the hinterlands of financial economics, fraught with pitfalls and danger.
The shadow rate can be negative at the ZLB; it is estimated using Treasury forward rates out to a 10-year horizon. Fortunately we don't need to take a jaunt into the hinterlands, because the paper's authors, Cynthia Wu and Dora Xia, have made their shadow rate publicly available. In fact, they write that all researchers have to do is "...update their favorite [statistical model] using the shadow rate for the ZLB period."
That's just what we did. We took five of our favorite models (Bayesian vector autoregressions, or BVARs) and spliced in the shadow rate starting in 1Q 2009. The shadow rate is currently hovering around minus 2 percent, suggesting a more accommodative environment than what the effective fed funds rate (stuck around 15 basis points) can deliver. Given the extra policy accommodation, we'd expect to see a bit more growth and a lower unemployment rate when using the shadow rate.
Before showing the average forecasts that come out of our models, we want to point out a few things. First, these are merely statistical forecasts and not the forecast that our boss brings with him to FOMC meetings. Second, there are alternative shadow rates out there. In fact, St. Louis Fed President James Bullard mentioned another one about a year ago based on work by Leo Krippner. At the time, that shadow rate was around minus 5 percent, much further below Wu and Xia's shadow rate (which was around minus 1.2 percent at the end of last year). Considering the disagreement between the two rates, we might want to take these forecasts with a grain of salt.
Caveats aside, we get a somewhat stronger path for real GDP growth and a lower unemployment rate path, consistent with what we'd expect additional stimulus to do. However, our core personal consumption expenditures inflation forecast seems to still be suffering from the dreaded price-puzzle. (We Googled it for you.)
Perhaps more important, the fed funds projections that emerge from this model appear to be much more believable. Rather than calling for an immediate liftoff, as the standard approach does, the average forecast of the shadow rate doesn't turn positive until the second half of 2015. This is similar to the most recent Wall Street Journal poll of economic forecasters, and the September New York Fed survey of primary dealers. The median respondent to that survey expects the first fed funds increase to occur in the third quarter of 2015. The shadow rate forecast has the added benefit of not being at odds with the current threshold-based guidance discussed in today's release of the minutes from the FOMC's October meeting.
Moreover, today's FOMC minutes stated, "modifications to the forward guidance for the federal funds rate could be implemented in the future, either to improve clarity or to add to policy accommodation, perhaps in conjunction with a reduction in the pace of asset purchases as part of a rebalancing of the Committee's tools." In this event, the shadow rate might be a useful scorecard for measuring the total effect of these policy actions.
It seems that if you want to summarize the stance of policy right now, just maybe...the shadow knows.
By Pat Higgins, senior economist, and
Brent Meyer, research economist, both of the Atlanta Fed's research department
August 19, 2013
Does Forward Guidance Reach Main Street?
The Federal Open Market Committee (FOMC) has been operating with two tools (well described in a recent speech by our boss here in Atlanta). The first is our large-scale asset purchase program, or QE to everyone outside of the Federal Reserve. The second is our forward guidance on the federal funds rate. Here’s what the fed funds guidance was following the July FOMC meeting:
[T]he Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee's 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored.
The quarterly projections of the June FOMC meeting participants give more specific guidance on the fed funds rate assuming “appropriate” monetary policy. All but one FOMC participant expects the funds rate to be lifted off the floor in 2015, with the median projection that the fed funds rate will be 1 percent by the end of 2015.
But forward guidance isn’t worth much if the public has a very different view of how long the fed funds rate will be held near zero. The Federal Reserve Bank of New York has a good read on Wall Street’s expectation for the federal funds rate. Its June survey of primary dealers (a set of institutions the Fed trades with when conducting open market operations) saw a 52 percent chance that the fed funds rate will rise from zero in 2015, and the median forecast of the group saw the fed funds rate at 0.75 percent at the end of 2015. In other words, the bond market is broadly in agreement with the fed funds rate projections made by FOMC meeting participants.
But what do we know about Main Street’s perspective on the fed funds rate? Do they even have an opinion on the subject?
Our perspective on Main Street comes from our panel of businesses who participate in the monthly Business Inflation Expectations (BIE) Survey. And we used our special question to the panel this month to see if we could gauge how, indeed whether, businesses have opinions about the future of the federal funds rate. Here’s the specific question we put to the group:
Currently the fed funds rate is near 0%. [In June, the Federal Reserve projected the federal funds rate to be 1% by the end of 2015.] Please assign a percentage likelihood to the following possible ranges for the federal funds rate at the end of 2015 (values should sum to 100%).
In the chart below, we plot the distribution of panelists’ median-probability forecast (the green bars) compared to the distribution of the FOMC’s June projection (we’ve simply smushed the FOMC’s dots into the appropriately categorized blue bars).
Seventy-five percent of our respondents had a median-probability forecast for the fed funds rate somewhere between 0.5 percent and 1.5 percent by the end of 2015. That forecast compares very closely to the 73 percent of the June FOMC meeting participants.
You may have noticed in the above question a bracketed bit of information about the Federal Reserve’s forecast for the federal funds rate: “In June, the Federal Reserve projected the federal funds rate to be 1% by the end of 2015.” Actually, this bit of extra information was supplied only to half of our panel (selected at random). A comparison between these two panel subsets is shown in the chart below.
These two subsets are very similar. (If you squint, you might see that the green bars appear a little more diffuse, but this isn’t a statistically significant difference…we checked.) This result suggests that the extra bit of information we provided was largely extraneous. Our business panel seems to have already had enough information on which to make an informed prediction about the federal funds rate.
Finally, the data shown in the two figures above are for those panelists who opted to answer the question we posed. But, at our instruction, not every firm chose to make a prediction for the federal funds rate. With this month’s special question, we instructed our panelists to “Please feel free to leave this question blank if you have no opinion.” A significant number of our panelists exercised this option.
The typical nonresponse rate from the BIE survey special question is about 2 percent. This month, it was 22 percent—which suggests that an unusually high share of our panel had no opinion on the future of the fed funds rate. What does this mean? Well, it could mean that a significant share of Main Street businesses are confused by the FOMC’s communications and are therefore unable to form an opinion. But a high nonresponse rate could also mean that some segment of Main Street businesses don’t believe that forward guidance on the fed funds rate affects their businesses much.
Unfortunately, the data we have don’t put us in a very good position to distinguish between confusion and apathy. Besides, we’re optimistic sorts. We’re going to emphasize that 78 percent of those businesses we surveyed responded to the question, and that typical response lined up pretty well with the opinions of FOMC meeting participants and the expectations of Wall Street. So, while not everyone is dialed in to our forward guidance, Main Street seems to get it.
By Mike Bryan, vice president and senior economist,
Brent Meyer, economist, and
Nicholas Parker, senior economic research analyst, all in the Atlanta Fed's research department
March 8, 2013
Will the Next Exit from Monetary Stimulus Really Be Different from the Last?
Suppose you run a manufacturing business—let's say, for example, widgets. Your customers are loyal and steady, but you are never completely certain when they are going to show up asking you to satisfy their widget desires.
Given this uncertainty, you consider two different strategies to meet the needs of your customers. One option is to produce a large quantity of widgets at once, store the product in your warehouse, and when a customer calls, pull the widgets out of inventory as required.
A second option is to simply wait until buyers arrive at your door and produce widgets on demand, which you can do instantaneously and in as large a quantity as you like.
Thinking only about whether you can meet customer demand when it presents itself, these two options are basically identical. In the first case you have a large inventory to support your sales. In the second case you have a large—in fact, infinitely large—"shadow" inventory that you can bring into existence in lockstep with demand.
I invite you to think about this example as you contemplate this familiar graph of the Federal Reserve's balance sheet:
I gather that a good measure of concern about the size of the Fed's (still growing) balance sheet comes from the notion that there is more inherent inflation risk with bank reserves that exceed $1.5 trillion than there would be with reserves somewhere in the neighborhood of $10 billion (which would be the ballpark value for the pre-crisis level of reserves).
I understand this concern, but I don't believe that it is entirely warranted. My argument is as follows: The policy strategy for tightening policy (or exiting stimulus) when the banking system is flush with reserves is equivalent to the strategy when the banking system has low (or even zero) reserves in the same way that the two strategies for meeting customer demand that I offered at the outset of this post are equivalent.
Here's why. Suppose, just for example, that bank reserves are literally zero and the Federal Open Market Committee (FOMC) has set a federal funds rate target of, say, 3 percent. Despite the fact that bank reserves are zero there is a real sense in which the potential size of the balance sheet—the shadow balance sheet, if you will—is very large.
The reason is that when the FOMC sets a target for the federal funds rate, it is sending very specific instructions to the folks from the Open Market Desk at the New York Fed, who run monetary policy operations on behalf of the FOMC. Those instructions are really pretty simple: If you have to inject more bank reserves (and hence expand the size of the Fed's balance sheet) to maintain the FOMC's funds rate target, do it.
To make sense of that statement, it is helpful to remember that the federal funds rate is an overnight interest rate that is determined by the supply and demand for bank reserves. Simplifying just a bit, the demand for reserves comes from the banking system, and the supply comes from the Fed. As in any supply and demand story, if demand goes up, so does the "price"—in this case, the federal funds rate.
In our hypothetical example, the Open Market Desk has been instructed not to let the federal funds rate deviate from 3 percent—at least not for very long. With such instructions, there is really only one thing to do in the case that demand from the banking system increases—create more reserves.
To put it in the terms of the business example I started out with, in setting a funds rate target the FOMC is giving the Open Market Desk the following marching orders: If customers show up, step up the production and meet the demand. The Fed's balance sheet in this case will automatically expand to meet bank reserve demand, just as the businessperson's inventory would expand to support the demand for widgets. As with the businessperson in my example, there is little difference between holding a large tangible inventory and standing ready to supply on demand from a shadow inventory.
Though the analogy is not completely perfect—in the case of the Fed's balance sheet, for example it is the banks and not the business (i.e., the Fed) that hold the inventory—I think the story provides an intuitive way to process the following comments (courtesy of Bloomberg) from Fed Chairman Ben Bernanke, from last week's congressional testimony:
"Raising interest rate on reserves" when the balance sheet is large is the functional equivalent to raising the federal funds rate when the actual balance sheet is not so large, but the potential or shadow balance sheet is. In both cases, the strategy is to induce banks to resist deploying available reserves to expand deposit liabilities and credit. The only difference is that, in the former case, the available reserves are explicit, and in the latter case they are implicit.
The Monetary Policy Report that accompanied the Chairman's testimony contained a fairly thorough summary of costs that might be associated with continued monetary stimulus. Some of these in fact pertain to the size of the Fed's balance sheet. But, as the Chairman notes in the video clip above, when it comes to the mechanics of exiting from policy stimulus, the real challenge is the familiar one of knowing when it is time to alter course.
By Dave Altig, executive vice president and research director of the Atlanta Fed
January 6, 2012
In the interest of precision
As you may have heard, the minutes of the December 13 meeting of the Federal Open Market Committee (FOMC) contained the news that, starting with this month's meeting, committee members will be jointly publishing not only their personal projections for gross domestic product growth, unemployment, and inflation, but also the monetary policy assumptions that underlie those forecasts. In an article published earlier this week, the enhancement to these projections, known as the Summary of Economic Projections (SEP), was described in the Wall Street Journal this way (with my emphasis added):
"Federal Reserve officials this month will begin detailing their plans for short-term interest rates, a move that could show that the central bank's easy-money policies will remain in place for years and give the economy a boost."
A similar description appeared in the Journal yesterday (again, emphasis added):
"The Fed has just taken a historic step towards increasing its transparency and accountability by saying it will begin to release interest-rate projections several years out at the conclusion of its next policy meeting on Jan. 25. This means Fed officials will soon let the world know exactly what path they believe interest rates will follow—and they, after all, set the path of interest rates."
I added the emphasis in both of those passages because I think the highlighted language isn't quite right. Here is the actual language that appears in the FOMC minutes:
"In the SEP, participants' projections for economic growth, unemployment, and inflation are conditioned on their individual assessments of the path of monetary policy that is most likely to be consistent with the Federal Reserve's statutory mandate to promote maximum employment and price stability, but information about those assessments has not been included in the SEP.…
"… participants decided to incorporate information about their projections of appropriate monetary policy into the SEP beginning in January. Specifically, the SEP will include information about participants' projections of the appropriate level of the target federal funds rate in the fourth quarter of the current year and the next few calendar years, and over the longer run; the SEP also will report participants' current projections of the likely timing of the first increase in the target rate given their projections of future economic conditions."
The minutes are pretty clear about what this information is intended to convey…
"Most participants agreed that adding their projections of the target federal funds rate to the economic projections already provided in the SEP would help the public better understand the Committee's monetary policy decisions and the ways in which those decisions depend on members' assessments of economic and financial conditions."
…and what it is not intended to convey (here too, emphasis added):
"Some participants expressed concern that publishing information about participants' individual policy projections could confuse the public; for example, they saw an appreciable risk that the public could mistakenly interpret participants' projections of the target federal funds rate as signaling the Committee's intention to follow a specific policy path rather than as indicating members' conditional projections for the federal funds rate given their expectations regarding future economic developments. Most participants viewed these concerns as manageable…"
In fact, the first Journal piece mentioned above does document some of the expressed concerns near the end of the article. For example:
"… some might mistakenly see the forecasts as an ironclad commitment, rather than a projection that could change as economy evolves."
That caveat does speak to concerns of some FOMC participants that the projections would establish a specific policy path. But the issue is about more than maintaining flexibility in the face of changing economic conditions. The broader point is that the new information in the SEPs, according to the minutes, is not intended to be a device for signaling the policy path that the FOMC, by official vote, intends to pursue.
This may seem like a small detail. But when it comes to the central bank's communications tools, even the small details matter.
By Dave Altig, senior vice president and research director at the Atlanta Fed
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