I was in New York on Friday attending the U.S. Monetary Policy Forum. One of the sessions was on how central banks could better communicate their plans for using unconventional monetary policy. Federal Reserve Bank of Chicago President Charles Evans presented some very interesting ideas.
Evans argued that the most important element for effective communication was for the Fed to make very clear what it is trying to achieve. Congress has given the Federal Reserve a dual mandate to maintain stable prices and maximum employment. But what does that actually mean in practice?
A large number of theoretical economic analyses represent this idea in terms of long-term target levels for inflation and unemployment. Suppose that our goal for monetary policy is to see an inflation rate around 2% and the unemployment rate close to 5.5%. We might then summarize how far off the Fed is from this long-term objective with a function like where π denotes the inflation rate as measured by the PCE deflator and u is the unemployment rate. With the inflation rate currently at 1.0% and the unemployment rate at 6.6%, that implies a value for the objective function of .
If we use a function like this to summarize what we’re hoping to achieve, we’d say that if the Fed were able to get the unemployment rate down to 6.0% but at the cost of bringing inflation up to 3.4%, we’d be no better off than we are right now: . The set of all points for which we’d be doing about as well as we are right now will be recognized as the equation for a circle: . We’d prefer to be on one of the smaller circles, closer to the bull’s eye on a figure like this:
Here’s how Evans interprets this:
This balanced approach implies strongly that our policy loss function can provide what I refer to as “bull’s-eye” accountability. This entire chart is like a simple “corporate scorecard” for our two-dimensional policy objectives in unemployment and inflation outcomes….
The most recent December 2013 Summary of Economic Projections shows that the Committee forecasts that unemployment and inflation will reach the bull’s-eye mark by the fourth quarter of 2016. This is a relatively slow attainment of our long-run goals. It also should be pointed out that these are still just projections of improvement, yet to be achieved. Nevertheless, the enhancements to our communications in recent years go a long way toward meeting our communications objectives by using this scorecard to depict progress toward our dual mandate goals….
my claim is that to be any good, monetary policy communications regarding policy actions must be consistent with the Fed expressing policy intentions clearly, so that the public can understand the Fed’s goals and its commitment to achieving these goals in a timely fashion. This should be a principle for all effective monetary policy strategies and communications: to state monetary policy intentions clearly.
I think Evans is making an excellent point. But I also agree with Federal Reserve Bank of Philadelphia President Charles Plosser, who observed as part of the same panel discussion “that dot in the middle is actually very big.” The truth is we don’t know with that much precision how low the Fed can really get the unemployment rate. Maybe 5.5% is an achievable target, as Evans’s figure above assumes. But it’s also possible that we’re not going to see an unemployment rate much below 6%, no matter how hard the Fed tries.
Nevertheless, I am very sympathetic to Evans’s suggestion. It is easy for reporters and financial analysts to get bogged down in the details of Fed operations regarding the size and pace of tapering and what will come after that. Using a figure like the above as akin to a corporate scorecard can help us all to better understand the kind of circumstances that would cause the Fed to change its operating tactics in pursuit of fixed goals, and to hold the Fed accountable for how it is doing.